Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds

DEPARTMENT OF THE TREASURY Office of the Comptroller of the Currency 12 CFR Part 44 [Docket No. OCC–2011–0014] RIN 1557–AD44 BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM 12 CFR Part 248 [Docket No. R–1432] RIN 7100 AD82 FEDERAL DEPOSIT INSURANCE CORPORATION 12 CFR Part 351 RIN 3064–AD85 SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 255 [Release No. BHCA–1; File No. S7–41–11] RIN 3235–AL07 Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds AGENCY: Office of the Comptroller of the Currency, Treasury (‘‘OCC’’); Board of Governors of the Federal Reserve System (‘‘Board’’); Federal Deposit Insurance Corporation (‘‘FDIC’’); and Securities and Exchange Commission (‘‘SEC’’). ACTION: Final rule. SUMMARY: The OCC, Board, FDIC, and SEC (individually, an ‘‘Agency,’’ and collectively, ‘‘the Agencies’’) are adopting a rule that would implement
section 13 of the BHC Act, which was
added by section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (‘‘Dodd-Frank Act’’).
Section 13 contains certain prohibitions
and restrictions on the ability of a banking entity and nonbank financial company supervised by the Board to engage in proprietary trading and have certain interests in, or relationships with, a hedge fund or private equity fund. DATES: The final rule is effective April 1, 2014. FOR FURTHER INFORMATION CONTACT:
OCC: Ursula Pfeil, Counsel, or Deborah Katz, Assistant Director, Legislative and Regulatory Activities Division, (202) 649–5490; Ted Dowd, Assistant Director, or Roman Goldstein, Senior Attorney, Securities and Corporate Practices Division, (202) 649– 5510; Kurt Wilhelm, Director for Financial Markets Group, (202) 649– 6360; Stephanie Boccio, Technical Expert for Credit and Market Risk Group, (202) 649–6360, Office of the Comptroller of the Currency, 250 E Street SW., Washington, DC 20219. Board: Christopher M. Paridon, Counsel, (202) 452–3274, or Anna M. Harrington, Senior Attorney, Legal Division, (202) 452–6406; Mark E. Van Der Weide, Deputy Director, Division of Bank Supervision and Regulation, (202) 452–2263; or Sean D. Campbell, Deputy Associate Director, Division of Research and Statistics, (202) 452–3760, Board of Governors of the Federal Reserve System, 20th and C Streets NW., Washington, DC 20551. FDIC: Bobby R. Bean, Associate Director, bbean@fdic.gov, or Karl R. Reitz, Chief, Capital Markets Strategies
Section, kreitz@fdic.gov, Capital
Markets Branch, Division of Risk Management Supervision, (202) 898– 6888; Michael B. Phillips, Counsel, mphillips@fdic.gov, or Gregory S. Feder, Counsel, gfeder@fdic.gov, Legal Division, Federal Deposit Insurance Corporation, 550 17th Street NW., Washington, DC 20429. SEC: Josephine J. Tao, Assistant Director, Angela R. Moudy, Branch Chief, John Guidroz, Branch Chief, Jennifer Palmer or Lisa Skrzycki, Attorney Advisors, Office of Trading Practices, Catherine McGuire, Counsel, Division of Trading and Markets, (202) 551–5777; W. Danforth Townley, Attorney Fellow, Jane H. Kim, Brian McLaughlin Johnson or Marian Fowler, Senior Counsels, Division of Investment Management, (202) 551–6787; David Beaning, Special Counsel, Office of Structured Finance, Division of Corporation Finance, (202) 551–3850; John Cross, Office of Municipal Securities, (202) 551–5680; or Adam Yonce, Assistant Director, or Matthew Kozora, Financial Economist, Division of Economic and Risk Analysis, (202) 551–6600, U.S. Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549. SUPPLEMENTARY INFORMATION:
Table of Contents
I. Background
II. Notice of Proposed Rulemaking
III. Overview of Final Rule
A. General Approach and Summary of Final Rule B. Proprietary Trading Restrictions
C. Restrictions on Covered Fund Activities
and Investments
D. Metrics Reporting Requirement E. Compliance Program Requirement
IV. Final Rule
A. Subpart B—Proprietary Trading Restrictions
1. Section ll.3: Prohibition on
Proprietary Trading and Related Definitions a. Definition of ‘‘Trading Account’’ b. Rebuttable Presumption for the ShortTerm Trading Account
c. Definition of ‘‘Financial Instrument’’
d. Proprietary Trading Exclusions
1. Repurchase and Reverse Repurchase
Arrangements and Securities Lending
2. Liquidity Management Activities
3. Transactions of Derivatives Clearing
Organizations and Clearing Agencies
4. Excluded Clearing-Related Activities of
Clearinghouse Members
5. Satisfying an Existing Delivery
Obligation
6. Satisfying an Obligation in Connection
With a Judicial, Administrative, SelfRegulatory Organization, or Arbitration Proceeding
7. Acting Solely as Agent, Broker, or
Custodian
8. Purchases or Sales Through a Deferred
Compensation or Similar Plan
9. Collecting a Debt Previously Contracted
10. Other Requested Exclusions
2. Section ll.4(a): Underwriting
Exemption a. Introduction b. Overview
1. Proposed Underwriting Exemption
2. Comments on Proposed Underwriting
Exemption
3. Final Underwriting Exemption
c. Detailed Explanation of the
Underwriting Exemption
1. Acting as an Underwriter for a
Distribution of Securities a. Proposed Requirements That the Purchase or Sale Be Effected Solely in Connection With a Distribution of Securities for Which the Banking Entity Acts as an Underwriter and That the Covered Financial Position be a Security
i. Proposed Definition of ‘‘Distribution’’
ii. Proposed Definition of ‘‘Underwriter’’
iii. Proposed Requirement That the
Covered Financial Position Be a Security b. Comments on the Proposed Requirements That the Trade Be Effected Solely in Connection With a Distribution for Which the Banking Entity Is Acting as an Underwriter and That the Covered Financial Position Be a Security
i. Definition of ‘‘Distribution’’
ii. Definition of ‘‘Underwriter’’
iii. ‘‘Solely in Connection With’’ Standard
c. Final Requirement That the Banking
Entity Act as an Underwriter for a Distribution of Securities and the Trading Desk’s Underwriting Position Be Related to Such Distribution
i. Definition of ‘‘Underwriting Position’’
ii. Definition of ‘‘Trading Desk’’
iii. Definition of ‘‘Distribution’’
iv. Definition of ‘‘Underwriter’’
v. Activities Conducted ‘‘in Connection
With’’ a Distribution
2. Near Term Customer Demand
Requirement

a. Proposed Near Term Customer Demand Requirement b. Comments Regarding the Proposed Near Term Customer Demand Requirement
c. Final Near Term Customer Demand
Requirement
3. Compliance Program Requirement
a. Proposed Compliance Program Requirement b. Comments on the Proposed Compliance Program Requirement
c. Final Compliance Program Requirement
4. Compensation Requirement
a. Proposed Compensation Requirement b. Comments on the Proposed Compensation Requirement
c. Final Compensation Requirement
5. Registration Requirement
a. Proposed Registration Requirement b. Comments on Proposed Registration Requirement
c. Final Registration Requirement
6. Source of Revenue Requirement
a. Proposed Source of Revenue Requirement b. Comments on the Proposed Source of Revenue Requirement
c. Final Rule’s Approach to Assessing
Source of Revenue
3. Section ll.4(b): Market-Making
Exemption a. Introduction b. Overview
1. Proposed Market-Making Exemption
2. Comments on the Proposed MarketMaking Exemption
a. Comments on the Overall Scope of the Proposed Exemption b. Comments Regarding the Potential Market Impact of the Proposed Exemption
3. Final Market-Making Exemption
c. Detailed Explanation of the MarketMaking Exemption
1. Requirement to Routinely Stand Ready
To Purchase And Sell a. Proposed Requirement To Hold Self Out b. Comments on the Proposed Requirement To Hold Self Out
i. The Proposed Indicia
ii. Treatment of Block Positioning Activity
iii. Treatment of Anticipatory Market
Making
iv. High-Frequency Trading
c. Final Requirement To Routinely Stand
Ready To Purchase And Sell
i. Definition of ‘‘Trading Desk’’
ii. Definitions of ‘‘Financial Exposure’’ and
‘‘Market-Maker Inventory’’
iii. Routinely Standing Ready To Buy and
Sell
2. Near Term Customer Demand
Requirement a. Proposed Near Term Customer Demand Requirement b. Comments Regarding the Proposed Near Term Customer Demand Requirement
i. The Proposed Guidance for Determining
Compliance With the Near Term Customer Demand Requirement
ii. Potential Inventory Restrictions and
Differences Across Asset Classes
iii. Predicting Near Term Customer
Demand
iv. Potential Definitions of ‘‘Client,’’
‘‘Customer,’’ or ‘‘Counterparty’’
v. Interdealer Trading and Trading for
Price Discovery or To Test Market Depth
vi. Inventory Management
vii. Acting as an Authorized Participant or
Market Maker in Exchange-Traded Funds
viii. Arbitrage or Other Activities That
Promote Price Transparency and Liquidity
ix. Primary Dealer Activities
x. New or Bespoke Products or Customized
Hedging Contracts
c. Final Near Term Customer Demand
Requirement
i. Definition of ‘‘Client,’’ ‘‘Customer,’’ and
‘‘Counterparty’’
ii. Impact of the Liquidity, Maturity, and
Depth of the Market on the Analysis
iii. Demonstrable Analysis of Certain
Factors
iv. Relationship to Required Limits
3. Compliance Program Requirement
a. Proposed Compliance Program Requirement b. Comments on the Proposed Compliance Program Requirement
c. Final Compliance Program Requirement
4. Market Making-Related Hedging
a. Proposed Treatment of Market MakingRelated Hedging b. Comments on the Proposed Treatment of Market Making-Related Hedging
c. Treatment of Market Making-Related
Hedging in the Final Rule
5. Compensation Requirement
a. Proposed Compensation Requirement b. Comments Regarding the Proposed Compensation Requirement
c. Final Compensation Requirement
6. Registration Requirement
a. Proposed Registration Requirement b. Comments on the Proposed Registration Requirement
c. Final Registration Requirement
7. Source of Revenue Analysis
a. Proposed Source of Revenue Requirement b. Comments Regarding the Proposed Source of Revenue Requirement
i. Potential Restrictions on Inventory,
Increased Costs for customers, and Other Changes To Market-Making Services
ii. Certain Price Appreciation-Related
Profits Are an Inevitable or Important Component of Market Making
iii. Concerns Regarding the Workability of
the Proposed Standard in Certain Markets or Asset Classes
iv. Suggested Modifications to the
Proposed Requirement
v. General Support for the Proposed
Requirement or for Placing Greater Restrictions on a Market Maker’s Sources of Revenue
c. Final Rule’s Approach To Assessing
Revenues
8. Appendix B of the Proposed Rule
a. Proposed Appendix B Requirement b. Comments on Proposed Appendix B
c. Determination To Not Adopt Proposed
Appendix B
9. Use of Quantitative Measurements
4. Section ll.5: Permitted RiskMitigating Hedging Activities
a. Summary of Proposal’s Approach to Implementing the Hedging Exemption b. Manner of Evaluating Compliance With the Hedging Exemption
c. Comments on the Proposed Rule and
Approach to Implementing the Hedging Exemption d. Final Rule
1. Compliance Program Requirement
2. Hedging of Specific Risks and
Demonstrable Reduction Of Risk
3. Compensation
4. Documentation Requirement
5. Section ll.6(a)–(b): Permitted Trading
in Certain Government and Municipal Obligations a. Permitted Trading in U.S. Government Obligations b. Permitted Trading in Foreign Government Obligations
c. Permitted Trading in Municipal
Securities d. Determination To Not Exempt Proprietary Trading in Multilateral Development Bank Obligations
6. Section ll.6(c): Permitted Trading on
Behalf of Customers a. Proposed Exemption for Trading on Behalf of Customers b. Comments on the Proposed Rule
c. Final Exemption for Trading on Behalf
of Customers
7. Section ll.6(d): Permitted Trading by
a Regulated Insurance Company
8. Section ll.6(e): Permitted Trading
Activities of a Foreign Banking Entity a. Foreign Banking Entities Eligible for the Exemption b. Permitted Trading Activities of a Foreign Banking Entity
9. Section ll.7: Limitations on Permitted
Trading Activities a. Scope of ‘‘Material Conflict of Interest’’
1. Proposed Rule
2. Comments on the Proposed Limitation
on Material Conflicts of Interest a. Disclosure b. Information Barriers
3. Final Rule
b. Definition of ‘‘High-Risk Asset’’ and ‘‘High-Risk Trading Strategy’’
1. Proposed Rule
2. Comments on Proposed Limitations on
High-Risk Assets and Trading Strategies
3. Final Rule
c. Limitations on Permitted Activities That
Pose a Threat to Safety and Soundness of the Banking Entity or the Financial Stability of the United States B. Subpart C—Covered Fund Activities and Investments
1. Section ll.10: Prohibition on
Acquisition or Retention of Ownership Interests in, and Certain Relationships With, a Covered Fund a. Prohibition Regarding Covered Fund Activities and Investments b. ‘‘Covered Fund’’ Definition
1. Foreign Covered Funds
2. Commodity Pools
3. Entities Regulated Under the Investment
Company Act
c. Entities Excluded From Definition of
Covered Fund
1. Foreign Public Funds
2. Wholly-Owned Subsidiaries
3. Joint Ventures
4. Acquisition Vehicles

1 Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111–203, 124 Stat. 1376 (2010). 2See 12 U.S.C. 1851. 3See 12 U.S.C. 1851(a)(2) and (f)(4). The Agencies note that two of the three companies currently designated by FSOC for supervision by the Board are affiliated with insured depository institutions, and are therefore currently banking entities for purposes of section 13 of the BHC Act. The Agencies are continuing to review whether the remaining company engages in any activity subject to section 13 of the BHC Act and what, if any, requirements apply under section 13. 4See 12 U.S.C. 1851(a)(1)(A) and (B). 5See id. at 1851(d)(1).
5. Foreign Pension or Retirement Funds
6. Insurance Company Separate Accounts
7. Bank Owned Life Insurance Separate
Accounts
8. Exclusion for Loan Securitizations and
Definition of Loan a. Definition of Loan b. Loan Securitizations
i. Loans
ii. Contractual Rights Or Assets
iii. Derivatives
iv. SUBIs and Collateral Certificates
v. Impermissible Assets
9. Asset-Backed Commercial Paper
Conduits
10. Covered Bonds
11. Certain Permissible Public Welfare and
Similar Funds
12. Registered Investment Companies and
Excluded Entities
13. Other Excluded Entities
d. Entities Not Specifically Excluded From the Definition of Covered Fund
1. Financial Market Utilities
2. Cash Collateral Pools
3. Pass-Through REITS
4. Municipal Securities Tender Option
Bond Transactions
5. Venture Capital Funds
6. Credit Funds
7. Employee Securities Companies
e. Definition of ‘‘Ownership Interest’’ f. Definition of ‘‘Resident of the United States’’ g. Definition of ‘‘Sponsor’’
2. Section ll.11: Activities Permitted in
Connection With Organizing and Offering a Covered Fund a. Scope of Exemption
1. Fiduciary Services
2. Compliance With Investment
Limitations
3. Compliance With Section 13(f) of the
BHC Act
4. No Guarantees or Insurance of Fund
Performance
5. Limitation on Name Sharing With a
Covered Fund
6. Limitation on Ownership By Directors
and Employees
7. Disclosure Requirements
b. Organizing and Offering an Issuing Entity of Asset-Backed Securities
c. Underwriting and Market Making for a
Covered Fund
3. Section ll.12: Permitted Investment in
a Covered Fund a. Proposed Rule b. Duration of Seeding Period for New Covered Funds
c. Limitations on Investments in a Single
Covered Fund (‘‘Per-Fund Limitation’’) d. Limitation on Aggregate Permitted Investments in All Covered funds (‘‘Aggregate Funds Limitation’’) e. Capital Treatment of an Investment in a Covered Fund f. Attribution of Ownership Interests to a Banking Entity g. Calculation of Tier 1 Capital h. Extension of Time to Divest Ownership Interest in a Single Fund
4. Section ll.13: Other Permitted
Covered Fund Activities a. Permitted Risk-Mitigating Hedging Activities b. Permitted Covered Fund Activities and Investments Outside of the United States
1. Foreign Banking Entities Eligible for the
Exemption
2. Activities or Investments Solely Outside
of the United States
3. Offered for Sale or Sold to a Resident of
the United States
4. Definition of ‘‘Resident of the United
States’’
c. Permitted Covered Fund Interests and
Activities by a Regulated Insurance Company
5. Section ll.14: Limitations on
Relationships With a Covered Fund a. Scope of Application b. Transactions That Would Be a ‘‘Covered Transaction’’
c. Certain Transactions and Relationships
Permitted
1. Permitted Investments and Ownerships
Interests
2. Prime Brokerage Transactions
d. Restrictions on Transactions With Any Permitted Covered Fund
6. Section ll.15: Other Limitations on
Permitted Covered Fund Activities
C. Subpart D and Appendices A and B—
Compliance Program, Reporting, and Violations
1. Section ll.20: Compliance Program
Mandate a. Program Requirement b. Compliance Program Elements
c. Simplified Programs for Less Active
Banking Entities d. Threshold for Application of Enhanced Minimum Standards
2. Appendix B: Enhanced Minimum
Standards for Compliance Programs a. Proprietary Trading Activities b. Covered Fund Activities or Investments
c. Enterprise-Wide Programs
d. Responsibility and Accountability e. Independent Testing f. Training g. Recordkeeping
3. Section ll.20(d) and Appendix A:
Reporting and Recordkeeping Requirements Applicable to Trading Activities a. Approach to Reporting and Recordkeeping Requirements Under the Proposal b. General Comments on the Proposed Metrics
c. Approach of the Final Rule
d. Proposed Quantitative Measurements and Comments on Specific Metrics
4. Section ll.21: Termination of
Activities or Investments; Authorities for Violations
V. Administrative Law Matters
A. Use of Plain Language
B. Paperwork Reduction Act Analysis
C. Regulatory Flexibility Act Analysis
D. OCC Unfunded Mandates Reform Act of 1995 Determination
I. Background
The Dodd-Frank Act was enacted on July 21, 2010.1 Section 619 of the DoddFrank Act added a new section 13 to the Bank Holding Company Act of 1956 (‘‘BHC Act’’) (codified at 12 U.S.C. 1851) that generally prohibits any banking entity from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with a hedge fund or private equity fund (‘‘covered fund’’), subject to certain exemptions.2 New section 13 of the BHC Act also provides that a nonbank financial company designated by the Financial Stability Oversight Council (‘‘FSOC’’) for supervision by the Board (while not a banking entity under
section 13 of the BHC Act) would be
subject to additional capital requirements, quantitative limits, or other restrictions if the company engages in certain proprietary trading or covered fund activities.3
Section 13 of the BHC Act generally
prohibits banking entities from engaging as principal in proprietary trading for the purpose of selling financial instruments in the near term or otherwise with the intent to resell in order to profit from short-term price movements.4 Section 13(d)(1) expressly exempts from this prohibition, subject to conditions, certain activities, including:

Trading in U.S. government, agency
and municipal obligations;
Underwriting and market makingrelated activities;
Risk-mitigating hedging activities;
Trading on behalf of customers;
Trading for the general account of
insurance companies; and
Foreign trading by non-U.S.
banking entities.5
Section 13 of the BHC Act also
generally prohibits banking entities from acquiring or retaining an ownership interest in, or sponsoring, a hedge fund or private equity fund.
Section 13 contains several exemptions
that permit banking entities to make limited investments in hedge funds and private equity funds, subject to a number of restrictions designed to ensure that banking entities do not rescue investors in these funds from loss and are not themselves exposed to

6See 12 U.S.C. 1851(a)(2) and (d)(4). 7See 12 U.S.C. 1851(b)(2). Under section 13(b)(2)(B) of the BHC Act, rules implementing
section 13’s prohibitions and restrictions must be
issued by: (i) The appropriate Federal banking agencies (i.e., the Board, the OCC, and the FDIC), jointly, with respect to insured depository institutions; (ii) the Board, with respect to any company that controls an insured depository institution, or that is treated as a bank holding company for purposes of section 8 of the International Banking Act, any nonbank financial company supervised by the Board, and any subsidiary of any of the foregoing (other than a subsidiary for which an appropriate Federal banking agency, the SEC, or the CFTC is the primary financial regulatory agency); (iii) the CFTC with respect to any entity for which it is the primary financial regulatory agency, as defined in
section 2 of the Dodd-Frank Act; and (iv) the SEC
with respect to any entity for which it is the primary financial regulatory agency, as defined in
section 2 of the Dodd-Frank Act. See id.
8See 76 FR 68846 (Nov. 7, 2011) (‘‘Joint Proposal’’). 9See 77 FR 23 (Jan. 23, 2012) (extending the comment period to February 13, 2012). 10See 77 FR 8332 (Feb. 14, 2012) (‘‘CFTC Proposal’’). 11See 12 U.S.C. 1851(b)(2)(B)(ii). The Secretary of the Treasury, as Chairperson of the FSOC, is responsible for coordinating the Agencies’ rulemakings under section 13 of the BHC Act. See id. 12See http://www.regulations.gov/#!docketDetail; D=OCC-2011-0014 (OCC); http://www.federal reserve.gov/newsevents/reform_systemic.htm (Board); http://www.fdic.gov/regulations/laws/ federal/2011/11comAD85.html (FDIC); http:// www.sec.gov/comments/s7-41-11/s74111.shtml (SEC); and http://www.cftc.gov/LawRegulation/ DoddFrankAct/Rulemakings/DF_28_VolckerRule/ index.htm (CFTC). 13See Commodity Futures Trading Commission, CFTC Staff to Host a Public Roundtable to Discuss the Proposed Volcker Rule (May 24, 2012), available at http://www.cftc.gov/PressRoom/ PressReleases/pr6263-12; transcript available at http://www.cftc.gov/ucm/groups/public/@ newsroom/documents/file/transcript053112.pdf. 14See Financial Stability Oversight Counsel, Study and Recommendations on Prohibitions on Proprietary Trading and Certain Relationships with Hedge Funds and Private Equity Funds (Jan. 18, 2011), available at http://www.treasury.gov/ initiatives/Documents/Volcker%20sec%20619% 20study%20final%201%2018%2011%20rg.pdf. (‘‘FSOC study’’). See 12 U.S.C. 1851(b)(1). Prior to publishing its study, FSOC requested public comment on a number of issues to assist in conducting its study. See 75 FR 61,758 (Oct. 6, 2010). Approximately 8,000 comments were received from the public, including from members of Congress, trade associations, individual banking entities, consumer groups, and individuals. significant losses from investments or other relationships with these funds.
Section 13 of the BHC Act does not
prohibit a nonbank financial company supervised by the Board from engaging in proprietary trading, or from having the types of ownership interests in or relationships with a covered fund that a banking entity is prohibited or restricted from having under section 13 of the BHC Act. However, section 13 of the BHC Act provides that these activities be subject to additional capital charges, quantitative limits, or other restrictions.6
II. Notice of Proposed Rulemaking:
Summary of General Comments Authority for developing and adopting regulations to implement the prohibitions and restrictions of section 13 of the BHC Act is divided among the Board, the Federal Deposit Insurance Corporation (‘‘FDIC’’), the Office of the Comptroller of the Currency (‘‘OCC’’), the Securities and Exchange Commission (‘‘SEC’’), and the Commodity Futures Trading Commission (‘‘CFTC’’).7 As required by
section 13(b)(2) of the BHC Act, the
Board, OCC, FDIC, and SEC in October 2011 invited the public to comment on proposed rules implementing that
section’s requirements.8 The period for
filing public comments on this proposal was extended for an additional 30 days, until February 13, 2012.9 In January 2012, the CFTC requested comment on a proposal for the same common rule to implement section 13 with respect to those entities for which it is the primary financial regulatory agency and invited public comment on its proposed implementing rule through April 16,
2012.10 The statute requires the
Agencies, in developing and issuing implementing rules, to consult and coordinate with each other, as appropriate, for the purposes of assuring, to the extent possible, that such rules are comparable and provide for consistent application and implementation of the applicable provisions of section 13 of the BHC Act.11 The proposed rules invited comment on a multi-faceted regulatory framework to implement section 13 consistent with the statutory language. In addition, the Agencies invited comments on the potential economic impacts of the proposed rule and posed a number of questions seeking information on the costs and benefits associated with each aspect of the proposal, as well as on any significant alternatives that would minimize the burdens or amplify the benefits of the proposal in a manner consistent with the statute. The Agencies also encouraged commenters to provide quantitative information and data about the impact of the proposal on entities subject to section 13, as well as on their clients, customers, and counterparties, specific markets or asset classes, and any other entities potentially affected by the proposed rule, including non-financial small and mid-size businesses. The Agencies received over 18,000 comments addressing a wide variety of aspects of the proposal, including definitions used by the proposal and the exemptions for market making-related activities, risk-mitigating hedging activities, covered fund activities and investments, the use of quantitative metrics, and the reporting proposals. The vast majority of these comments were from individuals using a version of a short form letter to express support for the proposed rule. More than 600 comment letters were unique comment letters, including from members of Congress, domestic and foreign banking entities and other financial services firms, trade groups representing banking, insurance, and the broader financial services industry, U.S. state and foreign governments, consumer and public interest groups, and individuals. To improve understanding of the issues raised by commenters, the Agencies met with a number of these commenters to discuss issues relating to the proposed rule, and summaries of these meetings are available on each of the Agency’s public Web sites.12 The CFTC staff also hosted a public roundtable on the proposed rule.13 Many of the commenters generally expressed support for the broader goals of the proposed rule. At the same time, many commenters expressed concerns about various aspects of the proposed rule. Many of these commenters requested that one or more aspects of the proposed rule be modified in some manner in order to reflect their viewpoints and to better accommodate the scope of activities that they argued were encompassed within section 13 of the BHC Act. The comments addressed all major sections of the proposed rule.
Section 13 of the BHC Act also
required the FSOC to conduct a study (‘‘FSOC study’’) and make recommendations to the Agencies by January 21, 2011 on the implementation of section 13 of the BHC Act. The FSOC study was issued on January 18, 2011. The FSOC study included a detailed discussion of key issues related to implementation of section 13 and recommended that the Agencies consider taking a number of specified actions in issuing rules under section 13 of the BHC Act.14 The FSOC study also recommended that the Agencies adopt a four-part implementation and supervisory framework for identifying and preventing prohibited proprietary trading, which included a programmatic compliance regime requirement for banking entities, analysis and reporting of quantitative metrics by banking entities, supervisory review and oversight by the Agencies, and

15See FSOC study at 5–6.
16See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); ABA (Keating); Chamber (Nov. 2011); Chamber (Nov. 2013); Members of Congress (Dec. 2011); IIAC; Real Estate Roundtable; Ass’n. of German Banks; Allen & Overy (Clearing); JPMC; Goldman (Prop. Trading); BNY Mellon et al.; State Street (Feb. 2012); ICI Global; Chamber (Feb. 2012); Socie´te´ Ge´ne´rale; HSBC; Western Asset Mgmt.; Abbott Labs et al. (Feb. 2012); PUC Texas; Columbia Mgmt.; ICI (Feb. 2012); IIB/EBF; British Bankers’ Ass’n.; ISDA (Feb. 2012); Comm. on Capital Markets Regulation; Ralph Saul (Apr. 2012); BPC. 17See 75 FR 61,758 (Oct. 6, 2010). 18 If any provision of this rule, or the application thereof to any person or circumstance, is held to be invalid, such invalidity shall not affect other provisions or application of such provisions to other persons or circumstances that can be given effect without the invalid provision or application. 19See 12 U.S.C. 1851(c)(1). 20See 12 U.S.C. 1851(c)(2); See also, A Conformance Period for Entities Engaged in Prohibited Proprietary Trading or Private Equity Fund or Hedge Fund Activities, 76 FR 8265 (Feb. 14, 2011) (citing 156 Cong. Rec. S5898 (daily ed. July 15, 2010) (statement of Sen. Merkley)). 21See, Board Order Approving Extension of Conformance Period, available at http:// www.federalreserve.gov/newsevents/press/bcreg/ bcreg20131210b1.pdf. enforcement procedures for violations.15 The Agencies carefully considered the FSOC study and its recommendations. In formulating this final rule, the Agencies carefully reviewed all comments submitted in connection with the rulemaking and considered the suggestions and issues they raise in light of the statutory restrictions and provisions as well as the FSOC study. The Agencies have sought to reasonably respond to all of the significant issues commenters raised. The Agencies believe they have succeeded in doing so notwithstanding the complexities involved. The Agencies also carefully considered different options suggested by commenters in light of potential costs and benefits in order to effectively implement section 13 of the BHC Act. The Agencies made numerous changes to the final rule in response to the issues and information provided by commenters. These modifications to the rule and explanations that address comments are described in more detail in the section-by-section description of the final rule. To enhance uniformity in both rules that implement section 13 and administration of the requirements of that section, the Agencies have been regularly consulting with each other in the development of this final rule. Some commenters requested that the Agencies repropose the rule and/or delay adoption pending the collection of additional information.16 As described in part above, the Agencies have provided many and various types of opportunities for commenters to provide input on implementation of section 13 of the BHC Act and have collected substantial information in the process. In addition to the
official comment process described above, members of the public submitted comment letters in advance of the official comment period for the proposed rules and met with staff of the Agencies to explain issues of concern; the public also provided substantial comment in response to a request for comment from the FSOC regarding its findings and recommendations for implementing
section 13.17 The Agencies provided a
detailed proposal and posed numerous questions in the preamble to the proposal to solicit and explore alternative approaches in many areas. In addition, the Agencies have continued to receive comment letters after the extended comment period deadline, which the Agencies have considered. Thus, the Agencies believe interested parties have had ample opportunity to review the proposed rules, as well as the comments made by others, and to provide views on the proposal, other comment letters, and data to inform our consideration of the final rules. In addition, the Agencies have been mindful of the importance of providing certainty to banking entities and financial markets and of providing sufficient time for banking entities to understand the requirements of the final rule and to design, test, and implement compliance and reporting systems. The further substantial delay that would necessarily be entailed by reproposing the rule would extend the uncertainty that banking entities would face, which could prove disruptive to banking entities and the financial markets. The Agencies note, as discussed more fully below, that the final rule incorporates a number of modifications designed to address the issues raised by commenters in a manner consistent with the statute. The preamble below also discusses many of the issues raised by commenters and explains the Agencies’ response to those comments. To achieve the purpose of the statute, without imposing unnecessary costs, the final rule builds on the multi-faceted approach in the proposal, which includes development and implementation of a compliance program at each banking entity engaged in trading activities or that makes investments subject to section 13 of the BHC Act; the collection and evaluation of data regarding these activities as an indicator of areas meriting additional attention by the banking entity and the relevant agency; appropriate limits on trading, hedging, investment and other activities; and supervision by the Agencies. To allow banking entities sufficient time to develop appropriate systems, the Agencies have provided for a phased-in schedule for the collection of data, limited data reporting requirements only to banking entities that engage in significant trading activity, and agreed to review the merits of the data collected and revise the data collection as appropriate over the next 21 months. Importantly, as explained in detail below, the Agencies have also reduced the compliance burden for banking entities with total assets of less than $10 billion. The final rule also eliminates compliance burden for firms that do not engage in covered activities or investments beyond investing in U.S. government obligations, agency guaranteed obligations, or municipal obligations. Moreover, the Agencies believe the data that will be collected in connection with the final rule, as well as the compliance efforts made by banking entities and the supervisory experience that will be gained by the
Agencies in reviewing trading and investment activity under the final rule, will provide valuable insights into the effectiveness of the final rule in achieving the purpose of section 13 of the BHC Act. The Agencies remain committed to implementing the final rule, and revisiting and revising the rule as appropriate, in a manner designed to ensure that the final rule faithfully implements the requirements and purposes of the statute.18 Finally, the Board has determined, in accordance with section 13 of the BHC Act, to provide banking entities with additional time to conform their activities and investments to the statute and the final rule. The restrictions and prohibitions of section 13 of the BHC Act became effective on July 21, 2012.19 The statute provided banking entities a period of two years to conform their activities and investments to the requirement of the statute, until July 21,
2014. Section 13 also permits the Board
to extend this conformance period, one year at a time, for a total of no more than three additional years.20 Pursuant to this authority and in connection with this rulemaking, the Board has in a separate action extended the conformance period for an additional year until July 21,
2015.21 The Board will continue to
monitor developments to determine whether additional extensions of the conformance period are in the public interest, consistent with the statute. Accordingly, the Agencies do not believe that a reproposal or further delay is necessary or appropriate. Commenters have differing views on the overall economic impacts of section 13 of the BHC Act.

22See, e.g., Oliver Wyman (Dec. 2011); Chamber (Dec. 2011); Thakor Study; Prof. Duffie; IHS. 23See Prof. Duffie. 24See IHS. 25See, e.g., Chamber (Dec. 2011); Thakor Study; Oliver Wyman (Dec. 2011); IHS. 26See, e.g., RBC; Citigroup (Feb. 2012); Goldman (Covered Funds). 27See, e.g., Profs. Admati & Pfleiderer; AFR (Nov. 2012); Better Markets (Dec. 2011); Better Markets (Feb. 2012); Occupy; Johnson & Prof. Stiglitz; Paul Volcker. 28See Occupy. 29See Profs. Admati & Pfleiderer; Better Markets (Feb. 2012); Occupy; Johnson & Prof. Stiglitz; Paul Volcker. 30See Profs. Admati & Pfleiderer; Johnson & Prof. Stiglitz. 31See AFR et al. (Feb. 2012); Better Markets (Apr. 16, 2012); David McClean; Public Citizen; Occupy. 32See Johnson & Prof. Stiglitz (citing Thomas Phillipon (2011)); AFR et al. (Feb. 2012); Occupy. 33See SIFMA et al. (Covered Funds) (Feb. 2012); BoA; ABA (Keating); Chamber (Feb. 2012); Socie´te´ Ge´ne´rale; FTN; SVB; ISDA (Feb. 2012); Comm. on Capital Market Regulation; Real Estate Roundtable. 34See, e.g., Better Markets (Feb. 2012); Randel Pilo. 35For example, with respect to the CFTC, Section 15(a) of the CEA requires such consideration only when ‘‘promulgating a regulation under this [Commodity Exchange] Act.’’ This final rule is not promulgated under the CEA, but under the BHC Act. CEA section 15(a), therefore, does not apply. Some commenters remarked that proprietary trading restrictions will have detrimental impacts on the economy such as: reduction in efficiency of markets, economic growth, and in employment due to a loss in liquidity.22 In particular, a commenter expressed concern that there may be high transition costs as non-banking entities replace some of the trading activities currently performed by banking entities.23 Another commenter focused on commodity markets remarked about the potential reduction in commercial output and curtailed resource exploration due to a lack of hedging counterparties.24 Several commenters stated that section 13 of the BHC Act will reduce access to debt markets—especially for smaller companies—raising the costs of capital for firms and lowering the returns on certain investments.25 Further, some commenters mentioned that U.S. banks may be competitively disadvantaged relative to foreign banks due to proprietary trading restrictions and compliance costs.26 On the other hand, other commenters stated that restricting proprietary trading activity by banking entities may reduce systemic risk emanating from the financial system and help to lower the probability of the occurrence of another financial crisis.27 One commenter contended that large banking entities may have a moral hazard incentive to engage in risky activities without allocating sufficient capital to them, especially if market participants believe these institutions will not be allowed to fail.28 Commenters argued that large banking entities may engage in activities that increase the upside return at the expense of downside loss exposure which
may ultimately be borne by Federal taxpayers 29 and that subsidies associated with bank funding may create distorted economic outcomes.30 Furthermore, some commenters remarked that non-banking entities may fill much of the void in liquidity provision left by banking entities if banking entities reduce their current trading activities.31 Finally, some commenters mentioned that hyperliquidity that arises from, for instance, speculative bubbles, may harm the efficiency and price discovery function of markets.32 The Agencies have taken these concerns into account in the final rule. As described below with respect to particular aspects of the final rule, the Agencies have addressed these issues by reducing burdens where appropriate, while at the same time ensuring that the final rule serves its purpose of promoting healthy economic activity. In that regard, the Agencies have sought to achieve the balance intended by Congress under section 13 of the BHC Act. Several comments suggested that a costs and benefits analysis be performed by the Agencies.33 On the other hand, some commenters 34 correctly stated that a costs and benefits analysis is not legally required.35 However, the Agencies find certain of the information submitted by commenters concerning costs and benefits and economic effects to be relevant to consideration of the rule, and so have considered this information as appropriate, and, on the basis of these and other considerations, sought to achieve the balance intended by Congress in section 619 of the DoddFrank Act. The relevant comments are addressed therein.
III. Overview of Final Rule
The Agencies are adopting this final rule to implement section 13 of the BHC Act with a number of changes to the proposal, as described further below. The final rule adopts a risk-based approach to implementation that relies on a set of clearly articulated characteristics of both prohibited and permitted activities and investments and is designed to effectively accomplish the statutory purpose of reducing risks posed to banking entities by proprietary trading activities and investments in or relationships with covered funds. As explained more fully below in the section-by-section analysis, the final rule has been designed to ensure that banking entities do not engage in prohibited activities or investments and to ensure that banking entities engage in permitted trading and investment activities in a manner designed to identify, monitor and limit the risks posed by these activities and investments. For instance, the final rule requires that any banking entity that is engaged in activity subject to section 13 develop and administer a compliance program that is appropriate to the size, scope and risk of its activities and investments. The rule requires the largest firms engaged in these activities to develop and implement enhanced compliance programs and regularly report data on trading activities to the Agencies. The Agencies believe this will permit banking entities to effectively engage in permitted activities, and the Agencies to enforce compliance with
section 13 of the BHC Act. In addition,
the enhanced compliance programs will help both the banking entities and the Agencies identify, monitor, and limit risks of activities permitted under
section 13, particularly involving
banking entities posing the greatest risk to financial stability. A. General Approach and Summary of Final Rule The Agencies have designed the final rule to achieve the purposes of section 13 of the BHC Act, which include prohibiting banking entities from engaging in proprietary trading or acquiring or retaining an ownership interest in, or having certain relationships with, a covered fund, while permitting banking entities to continue to provide, and to manage and limit the risks associated with providing, client-oriented financial services that are critical to capital generation for businesses of all sizes, households and individuals, and that facilitate liquid markets. These clientoriented financial services, which include underwriting, market making, and asset management services, are important to the U.S. financial markets and the participants in those markets. At the same time, providing appropriate latitude to banking entities to provide such client-oriented services need not and should not conflict with clear, robust, and effective implementation of the statute’s prohibitions and restrictions. As noted above, the final rule takes a multi-faceted approach to implementing
section 13 of the BHC Act. In particular,
the final rule includes a framework that clearly describes the key characteristics of both prohibited and permitted

36See final rule §ll.3(a).
37See final rule §ll.3(b).
38See final rule §ll.3(b)(1)(i).
39See final rule §ll.3(b)(2).
40See final rule §ll.3(b)(1)(ii).
41See final rule §ll.3(b)(1)(iii).
42See final rule §ll.3(d).
43See final rule §ll.3(c). activities. The final rule also requires banking entities to establish a comprehensive compliance program designed to ensure compliance with the requirements of the statute and rule in a way that takes into account and reflects the banking entity’s activities, size, scope and complexity. With respect to proprietary trading, the final rule also requires the large firms that are active participants in trading activities to calculate and report meaningful quantitative data that will assist both banking entities and the Agencies in identifying particular activity that warrants additional scrutiny to distinguish prohibited proprietary trading from otherwise permissible activities. As a matter of structure, the final rule is generally divided into four subparts and contains two appendices, as follows:

Subpart A of the final rule describes
the authority, scope, purpose, and relationship to other authorities of the rule and defines terms used commonly throughout the rule;
Subpart B of the final rule prohibits
proprietary trading, defines terms relevant to covered trading activity, establishes exemptions from the prohibition on proprietary trading and limitations on those exemptions, and requires certain banking entities to report quantitative measurements with respect to their trading activities;
Subpart C of the final rule prohibits
or restricts acquiring or retaining an ownership interest in, and certain relationships with, a covered fund, defines terms relevant to covered fund activities and investments, as well as establishes exemptions from the restrictions on covered fund activities and investments and limitations on those exemptions;
Subpart D of the final rule generally
requires banking entities to establish a compliance program regarding compliance with section 13 of the BHC Act and the final rule, including written policies and procedures, internal controls, a management framework, independent testing of the compliance program, training, and recordkeeping;
Appendix A of the final rule details
the quantitative measurements that certain banking entities may be required to compute and report with respect to certain trading activities;
Appendix B of the final rule details
the enhanced minimum standards for programmatic compliance that certain banking entities must meet with respect to their compliance program, as required under subpart D. B. Proprietary Trading Restrictions Subpart B of the final rule implements the statutory prohibition on proprietary trading and the various exemptions to this prohibition included in the statute.
Section ll.3 of the final rule contains
the core prohibition on proprietary trading and defines a number of related terms, including ‘‘proprietary trading’’ and ‘‘trading account.’’ The final rule’s definition of proprietary trading generally parallels the statutory definition and covers engaging as principal for the trading account of a banking entity in any transaction to purchase or sell specified types of financial instruments.36 The final rule’s definition of trading account also is consistent with the statutory definition.37 In particular, the definition of trading account in the final rule includes three classes of positions. First, the definition includes the purchase or sale of one or more financial instruments taken principally for the purpose of short-term resale, benefitting from short-term price movements, realizing short-term arbitrage profits, or hedging another trading account position.38 For purposes of this part of the definition, the final rule also contains a rebuttable presumption that the purchase or sale of a financial instrument by a banking entity is for the trading account of the banking entity if the banking entity holds the financial instrument for fewer than 60 days or substantially transfers the risk of the financial instrument within 60 days of purchase (or sale).39 Second, with respect to a banking entity subject to the Federal banking agencies’ Market Risk Capital Rules, the definition includes the purchase or sale of one or more financial instruments subject to the prohibition on proprietary trading that are treated as ‘‘covered positions and trading positions’’ (or hedges of other market risk capital rule covered positions) under those capital rules, other than certain foreign exchange and commodities positions.40 Third, the definition includes the purchase or sale of one or more financial instruments by a banking entity that is licensed or registered or required to be licensed or registered to engage in the business of a dealer, swap dealer, or security-based swap dealer to the extent the instrument is purchased or sold in connection with the activities that require the banking entity to be licensed or registered as such or is engaged in those businesses outside of the United States, to the extent the instrument is purchased or sold in connection with the activities of such business.41 The definition of proprietary trading also contains clarifying exclusions for certain purchases and sales of financial instruments that generally do not involve the requisite short-term trading intent, such as the purchase and sale of financial instruments arising under certain repurchase and reverse repurchase arrangements or securities lending transactions and securities acquired or taken for bona fide liquidity management purposes.42 In Section ll.3, the final rule also defines a number of other relevant terms, including the term ‘‘financial instrument.’’ This term is used to define the scope of financial instruments subject to the prohibition on proprietary
trading. Consistent with the statutory language, such financial instruments include securities, derivatives, commodity futures, and options on such instruments, but do not include loans, spot foreign exchange or spot physical commodities.43 In Section ll.4, the final rule implements the statutory exemptions for underwriting and market making-related activities. For each of these permitted activities, the final rule defines the exempt activity and provides a number of requirements that must be met in order for a banking entity to rely on the applicable exemption. As more fully discussed below, these include establishment and enforcement of a compliance program targeted to the activity; limits on positions, inventory and risk exposure addressing the requirement that activities be designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties; limits on the duration of holdings and positions; defined escalation procedures to change or exceed limits; analysis justifying established limits; internal controls and independent testing of compliance with limits; senior management accountability and limits on incentive compensation. In addition, the final rule requires firms with significant marketmaking or underwriting activities to report data involving several metrics that may be used by the banking entity and the Agencies to identify trading activity that may warrant more detailed compliance review. These requirements are generally designed to ensure that the banking

44See final rule §ll.4(a), (b).
45See final rule §ll.5.
46See final rule §ll.5(c).
47See final rule §ll.6(a).
48See final rule §ll.6(b).
49See final rule §ll.6(c).
50See final rule §ll.6(d).
51See final rule §ll.6(e).
52See final rule §ll.7.
53See final rule §ll.10(b).
54The Agencies believe that most securitization transactions are currently structured so that the issuing entity with respect to the securitization is not an affiliate of a banking entity under the BHC Act. However, with respect to any securitization that is an affiliate of a banking entity and that does not meet the requirements of the loan securitization exclusion, the related banking entity will need to determine how to bring the securitization into compliance with this rule. 55See final rule §ll.10(d)(6). 56See final rule §ll.10(b)(6)(ii). 57See 156 Cong. Rec. S5889 (daily ed. July 15,
2010) (statement of Sen. Hagan).
entity’s trading activity is limited to underwriting and market making-related activities and does not include prohibited proprietary trading.44 These requirements are also intended to work together to ensure that banking entities identify, monitor and limit the risks associated with these activities. In Section ll.5, the final rule implements the statutory exemption for risk-mitigating hedging. As with the underwriting and market-making exemptions, §ll.5 of the final rule contains a number of requirements that must be met in order for a banking entity to rely on the exemption. These requirements are generally designed to ensure that the banking entity’s hedging activity is limited to risk-mitigating hedging in purpose and effect.45 Section ll.5 also requires banking entities to document, at the time the transaction is executed, the hedging rationale for certain transactions that present heightened compliance risks.46 As with the exemptions for underwriting and market making-related activity, these requirements form part of a broader implementation approach that also includes the compliance program requirement and the reporting of quantitative measurements. In Section ll.6, the final rule implements statutory exemptions for trading in certain government obligations, trading on behalf of customers, trading by a regulated insurance company, and trading by certain foreign banking entities outside of the United States. Section ll.6(a) of the final rule describes the government obligations in which a banking entity may trade, which include U.S. government and agency obligations, obligations and other instruments of specified government sponsored entities, and State and municipal obligations.47 Section ll.6(b) of the final rule permits trading in certain foreign government obligations by affiliates of foreign banking entities in the United State and foreign affiliates of a U.S. banking entity abroad.48 Section ll.6(c) of the final rule describes permitted trading on behalf of customers and identifies the types of transactions that would qualify for the exemption.49 Section ll.6(d) of the final rule describes permitted trading by a regulated insurance company or an affiliate thereof for the general account of the insurance company, and also permits those entities to trade for a separate account of the insurance company.50 Finally, §ll.6(e) of the final rule describes trading permitted outside of the United States by a foreign banking entity.51 The exemption in the final rule clarifies when a foreign banking entity will qualify to engage in such trading pursuant to sections 4(c)(9) or 4(c)(13) of the BHC Act, as required by the statute, including with respect to a foreign banking entity not currently subject to the BHC Act. As explained in detail below, the exemption also provides that the risk as principal, the decision-making, and the accounting for this activity must occur solely outside of the United States, consistent with the statute. In Section
ll.7, the final rule prohibits a banking entity from relying on any exemption to the prohibition on proprietary trading if the permitted activity would involve or result in a material conflict of interest, result in a material exposure to high-risk assets or high-risk trading strategies, or pose a threat to the safety and soundness of the banking entity or to the financial stability of the United States.52 This
section also describes the terms material
conflict of interest, high-risk asset, and high-risk trading strategy for these purposes.
C. Restrictions on Covered Fund
Activities and Investments Subpart C of the final rule implements the statutory prohibition on, directly or indirectly, acquiring and retaining an ownership interest in, or having certain relationships with, a covered fund, as well as the various exemptions to this prohibition included in the statute.
Section ll.10 of the final rule contains
the core prohibition on covered fund activities and investments and defines a number of related terms, including ‘‘covered fund’’ and ‘‘ownership interest.’’ 53 The definition of covered fund contains a number of exclusions for entities that may rely on exclusions from the Investment Company Act of 1940 contained in section 3(c)(1) or 3(c)(7) of that Act but that are not engaged in investment activities of the type contemplated by section 13 of the BHC Act. These include, for example, exclusions for wholly owned subsidiaries, joint ventures, foreign pension or retirement funds, insurance company separate accounts, and public welfare investment funds. The final rule also implements the statutory rule of construction in section 13(g)(2) and provides that a securitization of loans, which would include loan securitization, qualifying asset backed commercial paper conduit, and qualifying covered bonds, is not covered by section 13 or the final rule.54 The definition of ‘‘ownership interest’’ in the final rule provides further guidance regarding the types of interests that would be considered to be an ownership interest in a covered fund.55 As described in this Supplementary Information, these interests may take various forms. The definition of ownership interest also explicitly excludes from the definition ‘‘restricted profit interest’’ that is solely performance compensation for services provided to the covered fund by the banking entity (or an employee or former employee thereof), under certain circumstances.56 Section ll.10 of the final rule also defines a number of other relevant terms, including the terms ‘‘prime brokerage transaction,’’ ‘‘sponsor,’’ and ‘‘trustee.’’
Section ll.11 of the final rule
implements the exemption for organizing and offering a covered fund provided for under section 13(d)(1)(G) of the BHC Act. Section ll.11(a) of the final rule outlines the conditions that must be met in order for a banking entity to organize and offer a covered fund under this authority. These requirements are contained in the statute and are intended to allow a banking entity to engage in certain traditional asset management and advisory businesses, subject to certain limits contained in section 13 of the BHC Act.57 The requirements are discussed in detail in Part IV.B.2. of this SUPPLEMENTARY INFORMATION. Section ll.11 also explains how these requirements apply to covered funds that are issuing entities of asset-backed securities, as well as implements the statutory exemption for underwriting and market-making ownership interests of a covered fund, including explaining the limitations imposed on such activities under the final rule. In Section ll.12, the final rule permits a banking entity to acquire and

58See final rule §ll.12.
59See final rule §ll.13(a)–(c).
60See 12 U.S.C. 371c; see also final rule §ll.14. 61 12 U.S.C. 371c–1. 62See final rule §ll.15. 63See final rule §ll.20(d)(3). The final rule includes a shorter period of time for reporting quantitative measurements than was proposed for the largest banking entities. Like the monthly reporting requirement for these firms, this is intended to allow for more effective supervision of their large-scale trading operations. retain, as an investment in a covered fund, an ownership interest in a covered fund that the banking entity organizes and offers or holds pursuant to other authority under § ll.11.58 This section implements section 13(d)(4) of the BHC Act and related provisions. Section 13(d)(4)(A) of the BHC Act permits a banking entity to make an investment in a covered fund that the banking entity organizes and offers, or for which it acts as sponsor, for the purposes of (i) establishing the covered fund and providing the fund with sufficient initial equity for investment to permit the fund to attract unaffiliated investors, or (ii) making a de minimis investment in the covered fund in compliance with applicable requirements. Section ll .12 of the final rule implements this authority and related limitations, including limitations regarding the amount and value of any individual perfund investment and the aggregate value of all such permitted investments. In addition, §ll.12 requires that the aggregate value of all investments in covered funds, plus any earnings on these investments, be deducted from the capital of the banking entity for purposes of the regulatory capital requirements, and explains how that deduction must occur. Section ll.12 of the final rule also clarifies how a banking entity must calculate its compliance with these investment limitations (including by deducting such investments from applicable capital, as relevant), and sets forth how a banking entity may request an extension of the period of time within which it must conform an investment in a single covered fund. This section also explains how a banking entity must apply the covered fund investment limits to a covered fund that is an issuing entity of asset backed securities or a covered fund that is part of a master-feeder or fund-of-funds structure. In Section ll.13, the final rule implements the statutory exemptions described in sections 13(d)(1)(C), (D), (F), and (I) of the BHC Act that permit a banking entity: (i) to acquire and retain an ownership interest in a covered fund as a risk-mitigating hedging activity related to employee compensation; (ii) in the case of a nonU.S. banking entity, to acquire and retain an ownership interest in, or act as sponsor to, a covered fund solely outside the United States; and (iii) to acquire and retain an ownership interest in, or act as sponsor to, a covered fund by an insurance company for its general or separate accounts.59 In Section ll.14, the final rule implements section 13(f) of the BHC Act and generally prohibits a banking
entity from entering into certain transactions with a covered fund that would be a covered transaction as defined in
section 23A of the Federal Reserve
Act.60 Section ll.14(a)(2) of the final rule describes the transactions between a banking entity and a covered fund that remain permissible under the statute and the final rule. Section ll.14(b) of the final rule implements the statute’s requirement that any transaction permitted under section 13(f) of the BHC Act (including a prime brokerage transaction) between the banking entity and a covered fund is subject to section 23B of the Federal Reserve Act,61 which, in general, requires that the transaction be on market terms or on terms at least as favorable to the banking entity as a comparable transaction by the banking entity with an unaffiliated third party. In Section ll.15, the final rule prohibits a banking entity from relying on any exemption to the prohibition on acquiring and retaining an ownership interest in, acting as sponsor to, or having certain relationships with, a covered fund, if the permitted activity or investment would involve or result in a material conflict of interest, result in a material exposure to high-risk assets or high-risk trading strategies, or pose a threat to the safety and soundness of the banking entity or to the financial stability of the United States.62 This
section also describes material conflict
of interest, high-risk asset, and high-risk trading strategy for these purposes. D. Metrics Reporting Requirement Under the final rule, a banking entity that meets relevant thresholds specified in the rule must furnish the following quantitative measurements for each of its trading desks engaged in covered trading activity calculated in accordance with Appendix A:

Risk and Position Limits and Usage;
Risk Factor Sensitivities;
Value-at-Risk and Stress VaR;
Comprehensive Profit and Loss
Attribution;
Inventory Turnover;
Inventory Aging; and
Customer Facing Trade Ratio.
The final rule raises the threshold for metrics reporting from the proposal to capture only firms that engage in significant trading activity, identified at specified aggregate trading asset and liability thresholds, and delays the dates for reporting metrics through a phasedin approach based on the size of trading assets and liabilities. Specifically, the Agencies have delayed the reporting of metrics until June 30, 2014 for the largest banking entities that, together with their affiliates and subsidiaries, have trading assets and liabilities the average gross sum of which equal or exceed $50 billion on a worldwide consolidated basis over the previous four calendar quarters (excluding trading assets and liabilities involving obligations of or guaranteed by the United States or any agency of the United States). Banking entities with $25 billion or more in trading assets and liabilities and banking entities with $10 billion or more in trading assets and liabilities would also be required to report these metrics beginning on April 30, 2016, and December 31, 2016, respectively. Under the final rule, a banking entity required to report metrics must calculate any applicable quantitative measurement for each trading day. Each banking entity required to report must report each applicable quantitative measurement to its primary supervisory Agency on the reporting schedule established in the final rule unless otherwise requested by the primary supervisory Agency for the entity. The largest banking entities with $50 billion in consolidated trading assets and liabilities must report the metrics on a monthly basis. Other banking entities required to report metrics must do so on a quarterly basis. All quantitative measurements for any calendar month must be reported no later than 10 days after the end of the calendar month required by the final rule unless another time is requested by the primary supervisory Agency for the entity except for a transitional six month period during which reporting will be required no later than 30 days after the end of the calendar month. Banking entities subject to quarterly reporting will be required to report quantitative measurements within 30 days of the end of the quarter, unless another time is requested by the primary supervisory Agency for the entity in writing.63

64See final rule §ll.20. 65See final rule §ll.20(f)(1). 66See final rule §ll.20(f)(2). 67 12 U.S.C. 1851(a)(1)(A). 68 12 U.S.C. 1851(h)(4). 69See Joint Proposal, 76 FR 68,857. 70See, e.g., Ass’n. of Institutional Investors (Feb. 2012); Capital Group; Comm. on Capital Markets Regulation; IAA; SIFMA et al. (Prop. Trading) (Feb. 2012); SVB; Chamber (Feb. 2012); Wellington. 71See Ass’n. of Institutional Investors (Feb. 2012); GE (Feb. 2012); Invesco; Sen. Corker; Chamber (Feb. 2012). 72See Chamber (Feb. 2012). 73See Japanese Bankers Ass’n. 74See, e.g., ABA (Keating); Ass’n. of Institutional Investors (Feb. 2012); BOK; George Bollenbacher; Credit Suisse (Seidel); NAIB et al.; SSgA (Feb. 2012); JPMC. 75See Public Citizen. 76See Sens. Merkley & Levin (Feb. 2012). 77See generally Occupy; Public Citizen; AFR et al. (Feb. 2012). The Agencies received over fifteen thousand form letters in support of a rule with few exemptions, many of which expressed a desire to return to the regulatory scheme as governed by the Glass-Steagall affiliation provisions of the U.S. Banking Act of 1933, as repealed through the Graham-Leach-Bliley Act of 1999. See generally Sarah McGee; Christopher Wilson; Michael Itlis; Barry Rein; Edward Bright. Congress rejected such an approach, however, opting instead for the more narrowly tailored regulatory approach embodied in
section 13 of the BHC Act.
E. Compliance Program Requirement Subpart D of the final rule requires a banking entity engaged in covered trading activities or covered fund activities to develop and implement a program reasonably designed to ensure and monitor compliance with the prohibitions and restrictions on covered trading activities and covered fund activities and investments set forth in
section 13 of the BHC Act and the final
rule.64 To reduce the overall burden of the rule, the final rule provides that a banking entity that does not engage in covered trading activities (other than trading in U.S. government or agency obligations, obligations of specified government sponsored entities, and state and municipal obligations) or covered fund activities and investments need only establish a compliance program prior to becoming engaged in such activities or making such investments.65 In addition, to reduce the burden on smaller banking entities, a banking entity with total consolidated assets of $10 billion or less that engages in covered trading activities and/or covered fund activities or investments may satisfy the requirements of the final rule by including in its existing compliance policies and procedures appropriate references to the requirements of section 13 and the final rule and adjustments as appropriate given the activities, size, scope and complexity of the banking entity.66 For banking entities with total assets greater than $10 billion and less than $50 billion, the final rule specifies six elements that each compliance program established under subpart D must, at a minimum, include. These requirements focus on written policies and procedures reasonably designed to ensure compliance with the final rules, including limits on underwriting and market-making; a system of internal controls; clear accountability for compliance and review of limits, hedging, incentive compensation, and other matters; independent testing and audits; additional documentation for covered funds; training; and recordkeeping requirements. A banking entity with $50 billion or more total consolidated assets (or a foreign banking entity that has total U.S. assets of $50 billion or more) or that is required to report metrics under
Appendix A is required to adopt an
enhanced compliance program with more detailed policies, limits, governance processes, independent testing and reporting. In addition, the Chief Executive Officer of these larger banking entities must attest that the banking entity has in place a program reasonably designed to achieve compliance with the requirements of
section 13 of the BHC Act and the final
rule.
The application of detailed minimum standards for these types of banking entities is intended to reflect the heightened compliance risks of large covered trading activities and covered fund activities and investments and to provide clear, specific guidance to such banking entities regarding the compliance measures that would be required for purposes of the final rule.
IV. Final Rule
A. Subpart B—Proprietary Trading Restrictions

Section ll.3: Prohibition on
Proprietary Trading and Related Definitions
Section 13(a)(1)(A) of the BHC Act
prohibits a banking entity from engaging in proprietary trading unless otherwise permitted in section 13.67 Section 13(h)(4) of the BHC Act defines proprietary trading, in relevant part, as engaging as principal for the trading account of the banking entity in any transaction to purchase or sell, or otherwise acquire or dispose of, a security, derivative, contract of sale of a commodity for future delivery, or other financial instrument that the Agencies include by rule.68
Section ll.3(a) of the proposed rule
implemented section 13(a)(1)(A) of the BHC Act by prohibiting a banking entity from engaging in proprietary trading unless otherwise permitted under §§ ll.4 through ll.6 of the proposed rule. Section ll.3(b)(1) of the proposed rule defined proprietary trading in accordance with section 13(h)(4) of the BHC Act and clarified that proprietary trading does not include acting solely as agent, broker, or custodian for an unaffiliated third party. The preamble to the proposed rule explained that acting in these types of capacities does not involve trading as principal.69 Several commenters expressed concern about the breadth of the ban on proprietary trading.70 Some of these commenters stated that proprietary trading must be carefully and narrowly defined to avoid prohibiting activities that Congress did not intend to limit and to preclude significant, unintended consequences for capital markets, capital formation, and the broader economy.71 Some commenters asserted that the proposed definition could result in banking entities being unwilling to take principal risk to provide liquidity for institutional investors; could unnecessarily constrain liquidity in secondary markets, forcing asset managers to service client needs through alternative non-U.S. markets; could impose substantial costs for all institutions, especially smaller and midsize institutions; and could drive risktaking to the shadow banking system.72 Others urged the Agencies to determine that trading as agent, broker, or custodian for an affiliate was not proprietary trading.73 Commenters also suggested alternative approaches for defining proprietary trading. In general, these approaches sought to provide a brightline definition to provide increased certainty to banking entities74 or make the prohibition easier to apply in practice.75 One commenter stated the Agencies should focus on the economics of banking entities’ transactions and ban trading if the banking entity is exposed to market risk for a significant period of time or is profiting from changes in the value of the asset.76 Several commenters, including individual members of the public, urged the Agencies to prohibit banking entities from engaging in any kind of proprietary trading and require separation of trading from traditional banking activities.77 After carefully considering comments, the Agencies are defining proprietary trading as engaging as principal for the trading account of the banking entity in any purchase or sale of one or more

78See final rule §ll.3(a). The final rule also replaces all references to the proposed term ‘‘covered financial position’’ with the term ‘‘financial instrument.’’ This change has no substantive impact because the definition of ‘‘financial instrument’’ is substantially identical to the proposed definition of ‘‘covered financial position.’’ Consistent with this change, the final rule replaces the undefined verbs ‘‘acquire’’ or ‘‘take’’ with the defined terms ‘‘purchase’’ or ‘‘sale’’ and ‘‘sell.’’ See final rule §§ll.3(c), ll.2(u), (x). 79See, e.g., Ass’n. of Institutional Investors (Feb. 2012); GE (Feb. 2012); Invesco; Sen. Corker; Chamber (Feb. 2012); JPMC. 80See 156 Cong. Rec. S5895–96 (daily ed. July 15,
2010) (statement of Sen. Merkley) (stating the
statute ‘‘permits underwriting and market-makingrelated transactions that are technically trading for the account of the firm but, in fact, facilitate the provision of near-term client-oriented financial services.’’). 81See ABA (Keating); Ass’n. of Institutional Investors (Feb. 2012); BOK; George Bollenbacher; Credit Suisse (Seidel); NAIB et al.; SSgA (Feb. 2012); JPMC. 82See, e.g., AllianceBernstein; Obaid Syed; Rep. Bachus et al.; EMTA; NASP; Sen. Hagan; Investure; Lord Abbett; Sumitomo Trust; EFAMA; Morgan Stanley; Barclays; BoA; Citigroup (Feb. 2012); STANY; ABA (Keating); ICE; ICSA; SIFMA (Asset Mgmt.) (Feb. 2012); Putnam; ACLI (Feb. 2012); Wells Fargo (Prop. Trading); Capital Group; RBC; Columbia Mgmt.; SSgA (Feb. 2012); Fidelity; ICI (Feb. 2012); ISDA (Feb. 2012); Comm. on Capital Markets Regulation; Clearing House Ass’n.; Thakor Study. See also CalPERS (acknowledging that the systemic protections afforded by the Volcker Rule come at a price, including reduced liquidity to all markets). 83See, e.g., AllianceBernstein; Obaid Syed; NASP; Investure; Lord Abbett; CalPERS; Credit Suisse (Seidel); Citigroup (Feb. 2012); ABA (Keating); SIFMA (Asset Mgmt.) (Feb. 2012); Putnam; Wells Fargo (Prop. Trading); Comm. on Capital Markets Regulation. 84See, e.g., Rep. Bachus et al.; Members of Congress (Dec. 2011); Lord Abbett; Morgan Stanley; Barclays; BoA; Citigroup (Feb. 2012); ABA (Abernathy); ICSA; SIFMA (Asset Mgmt.) (Feb. 2012); Chamber (Feb. 2012); Putnam; ACLI (Feb. 2012); UBS; Wells Fargo (Prop. Trading); Capital Group; Sen. Carper et al.; Fidelity; Invesco; Clearing House Ass’n.; Thakor Study. 85See, e.g., CalPERS (expressing the belief that a decline in banking entity proprietary trading will increase the volatility of the corporate bond market, especially during times of economic weakness or periods where risk taking declines, but noting that portfolio managers have experienced many different periods of market illiquidity and stating that the market will adapt post-implementation (e.g., portfolio managers will increase their use of CDS to reduce economic risk to specific bond positions as the liquidation process of cash bonds takes more time, alternative market matching networks will be developed)); Morgan Stanley; Capital Group; Fidelity; British Bankers’ Ass’n.; Invesco. 86See David McClean; Public Citizen; Occupy. In response to commenters who expressed concern about risks associated with proprietary trading activities moving to non-banking entities, the Agencies note that section 13’s prohibition on proprietary trading and related exemptions apply only to banking entities. See, e.g., Chamber (Feb. 2012). 87See final rule §ll.3(d). 88See 12 U.S.C. 1851(h)(6). 89See proposed rule §ll.3(b)(2)(i)(A). 90See proposed rule §ll.3(b)(2)(ii). 91See proposed rule §§ll.3(b)(2)(i)(B); ll .3(b)(3). financial instruments.78 The Agencies believe this effectively restates the statutory definition. The Agencies are not adopting commenters’ suggested
modifications to the proposed definition of proprietary trading or the general prohibition on proprietary trading because they generally appear to be inconsistent with Congressional intent. For instance, some commenters appeared to suggest an approach to defining proprietary trading that would capture only bright-line, speculative proprietary trading and treat the activities covered by the statutory exemptions as completely outside the rule.79 However, such an approach would appear to be inconsistent with Congressional intent because, for instance, it would not give effect to the limitations on permitted activities in
section 13(d) of the BHC Act.80 For
similar reasons, the Agencies are not adopting a bright-line definition of proprietary trading.81 A number of commenters expressed concern that, as a whole, the proposed rule may result in certain negative economic impacts, including: (i) Reduced market liquidity; 82 (ii) wider spreads or otherwise increased trading costs; 83 (iii) higher borrowing costs for businesses or increased cost of capital; 84 and/or (iv) greater market volatility.85 The Agencies have carefully considered commenters’ concerns about the proposed rule’s potential impact on overall market liquidity and quality. As discussed in more detail in Parts IV.A.2. and IV.A.3., the final rule will permit banking entities to continue to provide beneficial market-making and underwriting services to customers, and therefore provide liquidity to customers and facilitate capital-raising. However, the statute upon which the final rule is based prohibits proprietary trading activity that is not exempted. As such, the termination of non-exempt proprietary trading activities of banking entities may lead to some general reductions in liquidity of certain asset classes. Although the Agencies cannot say with any certainty, there is good reason to believe that to a significant extent the liquidity reductions of this type may be temporary since the statute does not restrict proprietary trading activities of other market participants.86 Thus, over time, non-banking entities may provide much of the liquidity that is lost by restrictions on banking entities’ trading activities. If so, eventually, the detrimental effects of increased trading costs, higher costs of capital, and greater market volatility should be mitigated. To respond to concerns raised by commenters while remaining consistent with Congressional intent, the final rule has been modified to provide that certain purchases and sales are not proprietary trading as described in more detail below.87 a. Definition of ‘‘Trading Account’’ As explained above, section 13 defines proprietary trading as engaging as principal ‘‘for the trading account of the banking entity’’ in certain types of transactions. Section 13(h)(6) of the BHC Act defines trading account as any account used for acquiring or taking positions in financial instruments principally for the purpose of selling in the near-term (or otherwise with the intent to resell in order to profit from short-term price movements), and any such other accounts as the Agencies may, by rule, determine.88 The proposed rule defined trading account to include three separate accounts. First, the proposed definition of trading account included, consistent with the statute, any account that is used by a banking entity to acquire or take one or more covered financial positions for short-term trading purposes (the ‘‘short-term trading account’’).89 The proposed rule identified four purposes that would indicate short-term trading intent: (i) Short-term resale; (ii) benefitting from actual or expected
short-term price movements; (iii) realizing short-term arbitrage profits; or (iv) hedging one or more positions described in (i), (ii) or (iii). The proposed rule presumed that an account is a trading account if it is used to acquire or take a covered financial position (other than a position in the market risk rule trading account or the dealer trading account) that the banking entity holds for 60 days or less.90 Second, the proposed definition of trading account included, for certain entities, any account that contains positions that qualify for trading book capital treatment under the banking agencies’ market risk capital rules other than positions that are foreign exchange derivatives, commodity derivatives or contracts of sale of a commodity for delivery (the ‘‘market risk rule trading account’’).91 ‘‘Covered positions’’ under the banking agencies’ market-risk capital rules are positions that are generally held with the intent of sale in the short-term. Third, the proposed definition of trading account included any account used by a banking entity that is a securities dealer, swap dealer, or

92See proposed rule §ll.3(b)(2)(i)(C). 93See proposed rule §ll.3(b)(2)(i)(C)(5). 94See Joint Proposal, 76 FR 68,860. 95See proposed rule §ll.3(b)(2)(iii). 96See ABA (Keating); JPMC. 97See AFR et al. (Feb. 2012); Paul Volcker; Credit Suisse (Seidel); ISDA (Feb. 2012); Japanese Bankers Ass’n. 98See ABA (Keating); Allen & Overy (on behalf of Large Int’l Banks with U.S. Operations); Am. Express; BoA; Goldman (Prop. Trading); ISDA (Feb. 2012); Japanese Bankers Ass’n.; JPMC; SIFMA et al. (Prop.Trading) (Feb. 2012); State Street (Feb. 2012). 99See ABA (Keating); JPMC; SIFMA et al. (Prop.Trading) (Feb. 2012); State Street (Feb. 2012). 100See ABA (Keating); Credit Suisse (Seidel). 101See ABA (Keating); Ass’n. of Institutional Investors (Feb. 2012); BoA; Capital Group; IAA; Credit Suisse (Seidel); ICI (Feb. 2012); ISDA (Feb. 2012); NAIB et al.; SIFMA et al. (Prop.Trading) (Feb. 2012); SVB; Wellington. 102See ABA (Keating). 103See NAIB et al.; Occupy; but See Alfred Brock. 104See ABA; BoA; Goldman (Prop. Trading); ISDA (Feb. 2012); JPMC; SIFMA et al. (Prop.Trading) (Feb. 2012). 105See BoA; SIFMA et al. (Prop.Trading) (Feb. 2012). 106See ISDA (Feb. 2012). 107See ABA (Keating); BoA; Goldman (Prop. Trading); ISDA (Feb. 2012); JPMC. The banking agencies adopted a final rule that amends their respective market risk capital rules on August 30,
2012. See 77 FR 53,060 (Aug. 30, 2012). The
Agencies continued to receive and consider comments on the proposed rule to implement
section 13 of the BHC Act after that time.
108See ABA (Keating); Allen & Overy (on behalf of Large Int’l Banks with U.S. Operations); Am. Express; Goldman (Prop. Trading); ISDA (Feb. 2012); Japanese Bankers Ass’n.; JPMC; SIFMA et al. (Prop.Trading) (Feb. 2012). 109See ABA (Keating); Allen & Overy (on behalf of Large Int’l Banks with U.S. Operations); JPMC; State Street (Feb. 2012); ISDA (Feb. 2012); SIFMA et al. (Prop.Trading) (Feb. 2012). 110See ABA (Keating); Am. Express; Goldman (Prop. Trading); ISDA (Feb. 2012); JPMC. 111See Allen & Overy (on behalf of Large Int’l Banks with U.S. Operations); Am. Express; JPMC. 112See Sens. Merkley & Levin (Feb. 2012); Occupy. 113See, e.g., Public Citizen. 114See AFR et al. (Feb. 2012). 115See Alfred Brock. 116See AFR et al. (Feb. 2012). 117See ABA (Keating); Goldman (Prop. Trading); NAIB et al. 118See Japanese Bankers Ass’n.; Norinchukin. security-based swap dealer to acquire or take positions in connection with its dealing activities (the ‘‘dealer trading account’’).92 The proposed rule also included as a trading account any account used to acquire or take any covered financial position by a banking entity in connection with the activities of a dealer, swap dealer, or securitybased swap dealer outside of the United States.93 Covered financial positions held by banking entities that register or file notice as securities or derivatives dealers as part of their dealing activity were included because such positions are generally held for sale to customers upon request or otherwise support the firm’s trading activities (e.g., by hedging its dealing positions).94 The proposed rule also set forth four clarifying exclusions from the definition of trading account. The proposed rule provided that no account is a trading account to the extent that it is used to acquire or take certain positions under repurchase or reverse repurchase arrangements, positions under securities lending transactions, positions for bona fide liquidity management purposes, or positions held by derivatives clearing organizations or clearing agencies.95 Overall, commenters did not raise significant concerns with or objections to the short-term trading account. Several commenters argued that the definition of trading account should be limited to only this portion of the proposed definition of trading account.96 However, a few commenters raised concerns regarding the treatment of arbitrage trading under the proposed rule.97 Several commenters asserted that the proposed definition of trading account was too broad and covered trading not intended to be covered by the statute.98 Some of these commenters maintained that the Agencies exceeded their statutory authority under section 13 of the BHC Act in defining trading account to include the market risk rule trading account and dealer trading account, and argued that the definition should be limited to the short-term trading account definition.99 Commenters argued, for example, that an overly broad definition of trading account may cause
traditional bank activities important to safety and soundness of a banking entity to fall within the prohibition on proprietary trading to the detriment of banking organizations, customers, and financial markets.100 A number of commenters suggested modifying and narrowing the trading account definition to remove the implicit negative presumption that any position creates a trading account, or that all principal trading constitutes prohibited proprietary trading unless it qualifies for a narrowly tailored exemption, and to clearly exempt activities important to safety and soundness.101 For example, one commenter recommended that a covered financial position be considered a trading account position only if it qualifies as a GAAP trading position.102 A few commenters requested the Agencies define the phrase ‘‘short term’’ in the rule.103 Several commenters argued that the market risk rule should not be referenced as part of the definition of trading account.104 A few of these commenters argued instead that the capital treatment of a position be used only as an indicative factor rather than a dispositive test.105 One commenter thought that the market risk rule trading account was redundant because it includes only positions that have shortterm trading intent.106 Commenters also contended that it was difficult to consider and comment on this aspect of the proposal because the market risk capital rules had not been finalized.107 A number of commenters objected to the dealer trading account prong of the definition.108 Commenters asserted that this prong was an unnecessary and unhelpful addition that went beyond the requirements of section 13 of the BHC Act, and that it made the trading account determination more complex and difficult.109 In particular, commenters argued that the dealer trading account was too broad and introduced uncertainty because it presumed that dealers always enter into positions with short-term intent.110 Commenters also expressed concern about the difficulty of applying this test outside the United States and requested that, if this account is retained, the final rule be explicit about how it applies to a swap dealer outside the United States and treat U.S. swap dealers consistently.111 In contrast, other commenters contended that the proposed rule’s definition of trading account was too narrow, particularly in its focus on short-term positions,112 or should be simplified.113 One commenter argued that the breadth of the trading account definition was critical because positions excluded from the trading account definition would not be subject to the proposed rule.114 One commenter supported the proposed definition of trading account.115 Other commenters believed that reference to the marketrisk rule was an important addition to the definition of trading account. Some expressed the view that it should include all market risk capital rule covered positions and not just those requiring short-term trading intent.116 Certain
commenters proposed alternate definitions. Several commenters argued against using the term ‘‘account’’ and instead advocated applying the prohibition on proprietary trading to trading positions.117 Foreign banks recommended applying the definition of trading account applicable to such banks in their home country, if the home country provided a clear definition of this term.118 These commenters argued that new definitions in the proposed rule, like trading account, would require foreign banking

119See Japanese Bankers Ass’n.
120See Alfred Brock.
121See AFR et al. (Feb. 2012); Paul Volcker. 122See NAIB et al. See infra Part IV.A.1.d.2. (discussing the liquidity management exclusion). 123 12 U.S.C. 1851(h)(6). 124 In response to commenters’ concerns about the meaning of account, the Agencies note the term ‘‘trading account’’ is a statutory concept and does not necessarily refer to an actual account. Trading account is simply nomenclature for the set of transactions that are subject to the final rule’s restrictions on proprietary trading. See ABA (Keating); Goldman (Prop. Trading); NAIB et al. 125For example, several commenters’ concerns about the potential impact of the proposed definition of trading account were tied to the perceived narrowness of the proposed exemptions. See ABA (Keating); Ass’n. of Institutional Investors (Feb. 2012); BoA; Capital Group; IAA; Credit Suisse (Seidel); ICI (Feb. 2012); ISDA (Feb. 2012); NAIB et al.; SIFMA et al. (Prop. Trading) (Feb. 2012); SVB; Wellington. 126See Sens. Merkley & Levin (Feb. 2012). However, as discussed in this SUPPLEMENTARY INFORMATION, the Agencies are not prohibiting any trading that involves profiting from changes in the value of the asset, as suggested by this commenter, because permitted activities, such as market making, can involve price appreciation-related revenues. See infra Part IV.A.3. (discussing the final market-making exemption). 127See Joint Proposal, 76 FR 68,857–68,858. 128As a result, the Agencies are not excluding arbitrage trading from the trading account definition, as suggested by at least one commenter. See, e.g., Alfred Brock. 129See ISDA (Feb. 2012); JPMC; ABA (Keating); BoA; SIFMA et al. (Prop. Trading) (Feb. 2012). 130See Occupy. 131 12 CFR part 225, Appendix E. entities to develop new and complex procedures and expensive systems.119 Commenters also argued that various types of trading activities should be excluded from the trading account definition. For example, one commenter asserted that arbitrage trading should not be considered trading account activity,120 while other commenters argued that arbitrage positions and strategies are proprietary trading and should be included in the definition of trading account and prohibited by the final rule.121 Another commenter argued that the trading account should include only positions primarily intended, when the position is entered into, to profit from short-term changes in the value of the assets, and that liquidity investments that do not have price changes and that can be sold whenever the banking entity needs cash should be excluded from the trading account definition.122 After carefully reviewing the comments, the Agencies have determined to retain in the final rule the proposed approach for defining trading account that includes the short-term, market risk rule, and dealer trading accounts with modifications to address issues raised by commenters. The Agencies believe that this multi-prong approach is consistent with both the language and intent of section 13
of the BHC Act, including the express statutory authority to include ‘‘any such other account’’ as determined by the Agencies.123 The final definition effectuates Congress’s purpose to generally focus on short-term trading while addressing commenters’ desire for greater certainty regarding the definition of the trading account.124 In addition, the Agencies believe commenters’ concerns about the scope of the proposed definition of trading account are substantially addressed by the refined exemptions in the final rule for customer-oriented activities, such as market making-related activities, and the exclusions from proprietary trading.125 Moreover, the Agencies believe that it is appropriate to focus on the economics of a banking entity’s trading activity to help determine whether it is engaged in proprietary trading, as discussed further below.126 As explained above, the short-term trading prong of the definition largely incorporates the statutory provisions. This prong covers trading involving short-term resale, price movements, and arbitrage profits, and hedging positions that result from these activities. Specifically, the reference to short-term resale is taken from the statute’s definition of trading account. The Agencies continue to believe it is also appropriate to include in the short-term trading prong an account that is used by a banking entity to purchase or sell one or more financial instruments principally for the purpose of benefitting from actual or expected short-term price movements, realizing short-term arbitrage profits, or hedging one or more positions captured by the short-term trading prong. The provisions regarding price movements and arbitrage focus on the intent to engage in transactions to benefit from short-term price movements (e.g., entering into a subsequent transaction in the near term to offset or close out, rather than sell, the risks of a position held by the banking entity to benefit from a price movement occurring between the acquisition of the underlying position and the subsequent offsetting transaction) or to benefit from differences in multiple market prices, including scenarios where movement in those prices is not necessary to realize the intended profit.127 These types of transactions are economically equivalent to transactions that are principally for the purpose of selling in the near term or with the intent to resell to profit from short-term price movements, which are expressly covered by the statute’s definition of trading account. Thus, the Agencies believe it is necessary to include these provisions in the final rule’s short-term trading prong to provide clarity about the scope of the definition and to prevent evasion of the statute and final rule.128 In addition, like the proposed rule, the final rule’s short-term trading prong includes hedging one or more of the positions captured by this prong because the Agencies assume that a banking entity generally intends to hold the hedging position for
only so long as the underlying position is held. The remaining two prongs to the trading account definition apply to types of entities that engage actively in trading activities. Each prong focuses on analogous or parallel short-term trading activities. A few commenters stated these prongs were duplicative of the short-term trading prong, and argued the Agencies should not include these prongs in the definition of trading account, or should only consider them as non-determinative factors.129 To the extent that an overlap exists between the prongs of this definition, the Agencies believe they are mutually reinforcing, strengthen the rule’s effectiveness, and may help simplify the analysis of whether a purchase or sale is conducted for the trading account.130 The market risk capital prong covers trading positions that are covered positions for purposes of the banking agency market-risk capital rules, as well as hedges of those positions. Trading positions under those rules are positions held by the covered entity ‘‘for the purpose of short-term resale or with the intent of benefitting from actual or expected short-term price movements, or to lock-in arbitrage profits.’’ 131 This definition largely parallels the provisions of section 13(h)(4) of the BHC Act and mirrors the short-term trading account prong of both the proposed and final rules. Covered positions are trading positions under the rule that subject the covered entity to risks and exposures that must be actively managed and limited—a requirement consistent with the purposes of the section 13 of the BHC Act. Incorporating this prong into the trading account definition reinforces the consistency between governance of the types of positions that banking entities identify as ‘‘trading’’ for purposes of the market risk capital rules and those that are trading for purposes of the final rule under section 13 of the BHC Act. Moreover, this aspect of the final rule reduces the compliance burden on banking entities with substantial trading

132Accordingly, the Agencies are not using a position’s capital treatment as merely an indicative factor, as suggested by a few commenters. 133See Joint Proposal, 76 FR 68,860. 134See final rule §ll.3(b)(1)(iii). 135An insured depository institution may be registered as a swap dealer, but only the swap dealing activities that require it to be so registered are covered by the dealer trading account. If an insured depository institution purchases or sells a financial instrument in connection with activities of the insured depository institution that do not trigger registration as a swap dealer, such as lending, deposit-taking, the hedging of business risks, or other end-user activity, the financial instrument is included in the trading account only if the instrument falls within the statutory trading account under §ll.3(b)(1)(i) or the market risk rule trading account under §ll.3(b)(1)(ii) of the final rule. 136See final rule §§ll.3(b)(1)(i) and (ii). 137See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading). 138See, e.g., Goldman (Prop. Trading) (‘‘For instance, a banking entity’s market making-related activities with respect to credit trading may involve making a market in bonds (traded in a brokerdealer), single-name CDSs (in a security-based swap dealer) and CDS indexes (in a swap dealer). For regulatory or other reasons, these transactions could take place in different legal entities. . .’’). 139See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; Allen & Overy (on behalf of Large Int’l Banks with U.S. Operations). 140See final rule §ll.6(e). 141See Japanese Bankers Ass’n. 142See ABA (Keating). 143See Joint Proposal, 76 FR 68,859. activities by establishing a clear, brightline rule for determining that a trade is within the trading account.132 After reviewing comments, the Agencies also continue to believe that financial instruments purchased or sold by registered dealers in connection with their dealing activity are generally held with short-term intent and should be captured within the trading account. The Agencies believe the scope of the dealer prong is appropriate because, as noted in the proposal, positions held by a registered dealer in connection with its dealing activity are generally held for sale to customers upon request or otherwise support the firm’s trading activities (e.g., by hedging its dealing positions), which is indicative of shortterm intent.133 Moreover, the final rule includes a number of exemptions for the activities in which securities dealers, swap dealers, and security-based swap dealers typically engage, such as market making, hedging, and underwriting. Thus, the Agencies believe the broad scope of the dealer trading account is balanced by the exemptions that are designed to permit dealer entities to continue to engage in customer-oriented trading activities, consistent with the statute. This approach is designed to ensure that registered dealer entities are engaged in permitted trading
activities, rather than prohibited proprietary trading. The final rule adopts the dealer trading account substantially as proposed,134 with streamlining that eliminates the specific references to different types of securities and derivatives dealers. The final rule adopts the proposed approach to covering trading accounts of banking entities that regularly engage in the business of a dealer, swap dealer, or security-based swap dealer outside of the United States. In the case of both domestic and foreign entities, this provision applies only to financial instruments purchased or sold in connection with the activities that require the banking entity to be licensed or registered to engage in the business of dealing, which is not necessarily all of the activities of that banking entity.135 Activities of a banking entity that are not covered by the dealer prong may, however, be covered by the shortterm or market risk rule trading accounts if the purchase or sale satisfies the requirements of §§ll.3(b)(1)(i) or (ii).136 A few commenters stated that they do not currently analyze whether a particular activity would require dealer registration, so the dealer prong of the trading account definition would require banking entities to engage in a new type of analysis.137 The Agencies recognize that banking entities that are registered dealers may not currently engage in such an analysis with respect to their current trading activities and, thus, this may represent a new regulatory requirement for these entities. If the regulatory analysis otherwise engaged in by banking entities is substantially similar to the dealer prong analysis required under the trading account definition, then any increased compliance burden could be small or insubstantial.138 In response to commenters’ concerns regarding the application of this prong to banking entities acting as dealers in jurisdictions outside the United States,139 the Agencies continue to believe including the activities of a banking entity engaged in the business of a dealer, swap dealer, or securitybased swap dealer outside of the United States, to the extent the instrument is purchased or sold in connection with the activities of such business, is appropriate. As noted above, dealer activity generally involves short-term trading. Further, the Agencies are concerned that differing requirements for U.S. and foreign dealers may lead to regulatory arbitrage. For foreign banking entities acting as dealers outside of the United States that are eligible for the exemption for trading conducted by foreign banking entities, the Agencies believe the risk-based approach to this exemption in the final rule should help address the concerns about the scope of this prong of the definition.140 In response to one commenter’s suggestion that the Agencies define the term trading account to allow a foreign banking entity to use of the relevant foreign regulator’s definition of this term, where available, the Agencies are concerned
such an approach could lead to regulatory arbitrage and otherwise inconsistent applications of the rule.141 The Agencies believe this commenter’s general concern about the impact of the statute and rule on foreign banking entities’ activities outside the United States should be substantially addressed by the exemption for trading conducted by foreign banking entities under § ll.6(e) of the final rule. Finally, the Agencies have declined to adopt one commenter’s recommendation that a position in a financial instrument be considered a trading account position only if it qualifies as a GAAP trading position.142 The Agencies continue to believe that formally incorporating accounting standards governing trading securities is not appropriate because: (i) The statutory proprietary trading provisions under section 13 of the BHC Act applies to financial instruments, such as derivatives, to which the trading security accounting standards may not apply; (ii) these accounting standards permit companies to classify, at their discretion, assets as trading securities, even where the assets would not otherwise meet the definition of trading securities; and (iii) these accounting standards could change in the future without consideration of the potential impact on section 13 of the BHC Act and these rules.143 b. Rebuttable Presumption for the ShortTerm Trading Account The proposed rule included a rebuttable presumption clarifying when a covered financial position, by reason of its holding period, is traded with short-term intent for purposes of the short-term trading account. The Agencies proposed this presumption primarily to provide guidance to banking entities that are not subject to the market risk capital rules or are not covered dealers or swap entities and accordingly may not have experience evaluating short-term trading intent. In particular, § __.3(b)(2)(ii) of the proposed rule provided that an account would be presumed to be a short-term trading account if it was used to acquire

144See Japanese Bankers Ass’n.
145See Capital Group.
146See AFR et al. (Feb. 2012).
147See Sens. Merkley & Levin (Feb. 2012); Public Citizen (arguing that one-year demarks tax law covering short term capital gains). 148See Sens. Merkley & Levin (Feb. 2012). 149See Occupy. 150See Capital Group. 151See SIFMA et al. (Prop. Trading) (Feb. 2012). 152See ABA (Keating); Am. Express; Business Roundtable; Capital Group; ICI (Feb. 2012); Investure; JPMC; Liberty Global; STANY; Chamber (Feb. 2012). 153See ABA (Keating); JPMC; Chamber (Feb. 2012). 154See Am. Express; ICI (Feb. 2012). 155See ABA (Keating); Chamber (Feb. 2012). 156See AllianceBernstein; Business Roundtable; ICI (Feb. 2012); Investure; Liberty Global; STANY. Because the rebuttable presumption does not impact the availability of the exemptions for underwriting, market making, and other permitted activities, the Agencies do not believe this provision creates any additional burdens on permissible activities. 157See Am. Express (noting that most foreign exchange forward transactions settle in less than one week and are used as commercial payment instruments, and not speculative trades); Capital Group. 158See ABA (Keating). As discussed below in Part IV.C., the Agencies expect to continue to coordinate their supervisory efforts related to section 13 of the BHC Act and to share information as appropriate in order to effectively implement the requirements of that section and the final rule. 159See ABA (Keating); AllianceBernstein; Capital Group; Japanese Bankers Ass’n.; Liberty Global; JPMC. 160See NAIB et al.; Capital Group. 161See Japanese Bankers Ass’n. As noted above, the Agencies believe concerns about the impacts of the definition of trading account on foreign banking entity trading activity outside of the United States are substantially addressed by the final rule’s exemption for proprietary trading conducted by foreign banking entities in final rule § .6(e). 162 Id. 163See final rule § .3(b)(2). Commenters did not provide persuasive evidence of the benefits associated with a rebuttable presumption for positions held for greater or fewer than 60 days. 164See, e.g., Am. Express; Capital Group; Sens. Merkley & Levin (Feb. 2012). 165See Capital Group; AFR et al. (Feb. 2012); Sens. Merkley & Levin (Feb. 2012); Public Citizen; Occupy. 166The Agencies believe this should help address commenters’ concerns about the burdens associated with rebutting the presumption. See ABA (Keating); AllianceBernstein; Capital Group; Japanese Bankers Ass’n.; Liberty Global; JPMC; NAIB et al.; Capital Group. 167See, e.g., ABA (Keating); Clearing House Ass’n.; JPMC. 168The rebuttable presumption covered these trades in the proposal, but the final rule’s use of ‘‘financial instrument’’ rather than ‘‘covered financial position’’ necessitated clarifying this point in the rule text. See final rule § .3(b)(2). See also Public Citizen. 169The Agencies do not believe these revisions have a substantive effect on the operation or scope of the final rule in comparison to the statute or proposed rule. or take a
covered financial position that the banking entity held for a period of 60 days or less. Several commenters supported the rebuttable presumption, but suggested either shortening the holding period to 30 days or less,144 or extending the period to 90 days,145 to several months,146 or to one year.147 Some of these commenters argued that specifying an overly short holding period would be contrary to the statute, invite gamesmanship,148 and miss speculative positions held for longer than the specified period.149 Commenters also suggested turning the presumption into a safe harbor 150 or into guidance.151 Other commenters opposed the inclusion of the rebuttable presumption for a number of reasons and requested that it be removed.152 For example, these commenters argued that the presumption had no statutory basis; 153 was arbitrary; 154 was not supported by data, facts, or analysis; 155 would dampen market-making and underwriting activity; 156 or did not take into account the nature of trading in different types of securities.157 Some commenters also questioned whether the Agencies would interpret rebuttals of the presumption consistently,158 and stressed the difficulty and costliness of rebutting the presumption,159 such as enhanced documentation or other administrative burdens.160 One foreign banking association also argued that requiring foreign banking entities to rebut a U.S. regulatory requirement would be costly and inappropriate given that the trading activities of the banking entity are already reviewed by home country supervisors.161 This commenter also contended that the presumption could be problematic for financial instruments purchased for long-term investment purposes that are closed within 60 days due to market fluctuations or other changed circumstances.162 After carefully considering the comments received, the Agencies continue to believe the rebuttable presumption is appropriate to generally define the meaning of ‘‘short-term’’ for purposes of the short-term trading account, especially for small and regional banking entities that are not subject to the market risk capital rules and are not registered dealers or swap entities. The range of comments the Agencies received on what ‘‘short-term’’ should mean—from 30 days to one year—suggests that a clear presumption would ensure consistency in interpretation and create a level playing field for all banking entities with covered trading activities subject to the short-term trading account. Based on their supervisory experience, the Agencies find that 60 days is an appropriate cut off for a regulatory presumption.163 Further, because the purpose of the rebuttable presumption is to simplify the process of evaluating whether individual positions are included in the trading account, the Agencies believe that implementing different holding periods based on the type of financial instrument would insert unnecessary complexity into the presumption.164 The Agencies are not providing a safe harbor
or a reverse presumption (i.e., a presumption for positions that are outside of the trading account), as suggested by some commenters, in recognition that some proprietary trading could occur outside of the 60 day period.165 Adopting a presumption allows the Agencies and affected banking entities to evaluate all the facts and circumstances surrounding trading activity in determining whether the activity implicates the purpose of the statute. For example, trading in a financial instrument for long-term investment that is disposed of within 60 days because of unexpected developments (e.g., an unexpected increase in the financial instrument’s volatility or a need to liquidate the instrument to meet unexpected liquidity demands) may not be trading activity covered by the statute. To reduce the costs and burdens of rebutting the presumption, the Agencies will allow a banking entity to rebut the presumption for a group of related positions.166 The final rule provides three clarifying changes to the proposed rebuttable presumption. First, in response to comments, the final rule replaces the reference to an ‘‘account’’ that is presumed to be a trading account with the purchase or sale of a ‘‘financial instrument.’’ 167 This change clarifies that the presumption only applies to the purchase or sale of a financial instrument that is held for fewer than 60 days, and not the entire account that is used to make the purchase or sale. Second, the final rule clarifies that basis trades, in which a banking entity buys one instrument and sells a substantially similar instrument (or otherwise transfers the first instrument’s risk), are subject to the rebuttable presumption.168 Third, in order to maintain consistency with definitions used throughout the final rule, the references to ‘‘acquire’’ or ‘‘take’’ a financial position have been replaced with references to ‘‘purchase’’ or ‘‘sell’’ a financial instrument.169

170See 12 U.S.C. 1851(h)(4).
171See proposed rule § .3(c)(3)(i).
172See proposed rule § .3(c)(3)(ii). 173See proposed rule § .2(l), (q), (w); § .3(c)(1) and (2). 174See 7 U.S.C. 1a(47) (defining ‘‘swap’’); 15 U.S.C. 78c(a)(68) (defining ‘‘security-based swap’’). 175 7 U.S.C. 1a(24), (25). 176 7 U.S.C. 2(c)(2)(C)(i). 177 7 U.S.C. 2(c)(2)(D)(i). 178 7 U.S.C. 23. 179See Sens. Merkley & Levin (Feb. 2012); Public Citizen; Occupy. 180See Northern Trust; Morgan Stanley; JPMC; Credit Suisse (Seidel); Am. Express; See also AFR et al. (Feb. 2012) (arguing that the final rule should explicitly exclude ‘‘spot’’ commodities and foreign exchange). 181See Alfred Brock. 182See Credit Suisse (Seidel). 183See GE (Feb. 2012). 184See JPMC; BoA; Citigroup (Feb. 2012). 185See Govt. of Japan/Bank of Japan; Japanese Bankers Ass’n.; See also Norinchukin. 186See Northern Trust; Citigroup (Feb. 2012). 187See SIFMA et al. (Prop. Trading) (Feb. 2012).
c. Definition of ‘‘Financial Instrument’’
Section 13 of the BHC Act generally
prohibits proprietary trading, which is defined in section 13(h)(4) to mean engaging as principal for the trading account in any purchase or sale of any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative, or contract, or any other security or financial instruments that the Agencies may, by rule, determine.170 The proposed rule defined the term ‘‘covered financial position’’ to reference the instruments listed in
section 13(h)(4), including: (i) A
security, including an option on a security; (ii) a derivative, including an option on a derivative; or (iii) a contract of sale of a commodity for future delivery, or an option on such a contract.171 To provide additional clarity, the proposed rule also provided that, consistent with the statute, any position that is itself a loan, a commodity, or foreign exchange or currency was not a covered financial position.172 The proposal also defined a number of other terms used in the definition of covered financial position, including commodity, derivative, loan, and security.173 These terms were generally defined by reference to the federal securities laws or the Commodity Exchange Act because these existing definitions are generally wellunderstood by market participants and have been subject to extensive interpretation in the context of securities, commodities, and derivatives trading. As noted above, the proposed rule included derivatives within the definition of covered financial position. Derivative was defined to include any swap (as that term is defined in the Commodity Exchange Act) and securitybased swap (as that term is defined in the Exchange Act), in each case as further defined by the CFTC and SEC by joint regulation, interpretation, guidance, or other action, in consultation with the Board pursuant to
section 712(d) of the Dodd-Frank Act.174
The proposed rule also included within the definition of derivative certain other transactions that, although not included within the definition of swap or security-based swap, also appear to be, or operate in economic substance as, derivatives, and which if not included could permit banking entities to engage in proprietary trading that is inconsistent with the purpose of section 13 of the BHC Act. Specifically, the proposed definition also included: (i) Any purchase or sale of a nonfinancial commodity for deferred shipment or delivery that is intended to be physically settled; (ii) any foreign exchange forward or foreign exchange swap (as those terms are defined in the Commodity Exchange Act); 175 (iii) any agreement, contract, or transaction in foreign currency described in section 2(c)(2)(C)(i) of the Commodity Exchange Act; 176 (iv) any agreement, contract, or transactions in a commodity other than foreign currency described in section 2(c)(2)(D)(i) of the Commodity Exchange Act; 177 and (v) any transactions authorized under section 19 of the Commodity Exchange Act.178 In addition, the proposed rule excluded from the definition of derivative (i) any consumer, commercial, or other agreement, contract, or transaction that the CFTC and SEC have further defined by joint regulation, interpretation, guidance, or other action as not within the definition of swap or security-based swap, and (ii) any identified banking product, as defined in section 402(b) of the Legal Certainty for Bank Products Act of 2000 (7 U.S.C. 27(b)), that is subject to section 403(a) of that Act (7 U.S.C. 27a(a)). Commenters expressed a variety of views regarding the definition of covered financial position, as well as other defined terms used in that definition. For instance, some commenters argued that the definition should be expanded to include transactions in spot commodities or foreign currency, even though those instruments are not included by the statute.179 Other commenters strongly supported the exclusion of spot commodity and foreign currency transactions as consistent with the statute, arguing that these instruments are part of the traditional business of banking and do not represent the types of instruments that Congress designed
section 13 to address. These
commenters argued that including spot commodities and foreign exchange within the definition of covered financial position in the final rule would put U.S. banking entities at a competitive disadvantage and prevent them from conducting routine banking operations.180 One commenter argued that the proposed definition of covered financial position was effective and recommended that the definition should not be expanded.181 Another commenter argued that an instrument be considered to be a spot foreign exchange transaction, and thus not a covered financial position, if it settles within 5 days of purchase.182 Another commenter argued that covered financial positions used in interaffiliate transactions should expressly be excluded because they are used for internal risk management purposes and not for proprietary trading.183 Some commenters requested that the final rule exclude additional instruments from the definition of covered financial position. For instance, some commenters requested that the Agencies exclude commodity and foreign exchange futures, forwards, and swaps, arguing that these instruments typically have a commercial and not financial purpose and that making them subject to the prohibitions of section 13 would negatively affect the spot market for these instruments.184 A few commenters also argued that foreign exchange swaps and forwards are used in many jurisdictions to provide U.S. dollar-funding for foreign banking entities and that these instruments should be excluded since they contribute to the stability and liquidity of the market for spot foreign exchange.185 Other commenters contended that foreign exchange swaps and forwards should be excluded because they are an integral part of banking entities’ ability to provide trust and custody services to customers and are necessary to enable banking entities to deal in the exchange of currencies for customers.186 One commenter argued that the inclusion of certain instruments within the definition of derivative, such as purchases or sales of nonfinancial commodities for deferred shipment or delivery that are intended to be physically settled, was inappropriate.187 This commenter alleged that these instruments are not derivatives but

188See id.
189See SIFMA et al. (Prop.Trading) (Feb. 2012); ISDA (Feb. 2012). 190See Alfred Brock. 191The definition of security under the final rule is the same as under the proposal. See final rule §l l.2(y). 192See final rule § .3(c)(1). 193The definition of loan, as well as comments received regarding that definition, is discussed in detail below in Part IV.B.1.c.8.a. 194See final rule § .3(c)(2). 195See Sens. Merkley & Levin (Feb. 2012); Public Citizen; Occupy. 196See Occupy. 197Several commenters supported the exclusion of spot commodity and foreign currency transactions as consistent with the statute. See Northern Trust; Morgan Stanley; State Street (Feb. 2012); JPMC; Credit Suisse (Seidel); Am. Express; See also AFR et al. (Feb. 2012) (arguing that the final rule should explicitly exclude ‘‘spot’’ commodities and foreign exchange). One commenter stated that the proposed definition should not be expanded. See Alfred Brock. With respect to the exclusion for loans, the Agencies note this is generally consistent with the rule of statutory construction regarding the sale and securitization of loans. See 12 U.S.C. 1851(g)(2). 198See JPMC; BAC; Citigroup (Feb. 2012); Govt. of Japan/Bank of Japan; Japanese Bankers Ass’n.; Northern Trust; See also Norinchukin. 199See final rule §§ __.2(h), (y). 200See SIFMA et al. (Prop. Trading) (Feb. 2012); ISDA (Feb. 2012). 201See CFTC and SEC, Further Definition of ‘‘Swap,’’ ‘‘Security-Based Swap,’’ and ‘‘SecurityBased Swap Agreement’’; Mixed swaps; Security Based Swap Agreement Recordkeeping, 78 FR 48,208 (Aug. 13, 2012). should instead be viewed as contracts for purchase of specific commodities to be delivered at a future date. This commenter also argued that the Agencies do not have authority under
section 13 to include these instruments
as ‘‘other securities or financial instruments’’ subject to the prohibition on proprietary trading.188 Some commenters also argued that, because the CFTC and SEC had not yet finalized their definitions of swap and security-based swap, it was inappropriate to use those definitions as
part of the proposed definition of
derivative.189 One commenter argued that the definition of derivative was effective, although this commenter argued that the final rule should not cross-reference the definition of swap and security-based swap under the federal commodities and securities laws.190 After carefully considering the comments received on the proposal, the final rule continues to apply the prohibition on proprietary trading to the same types of instruments as listed in the statute and the proposal, which the final rule defines as ‘‘financial instrument.’’ Under the final rule, a financial instrument is defined as: (i) A security, including an option on a security; 191 (ii) a derivative, including an option on a derivative; or (iii) a contract of sale of a commodity for future delivery, or option on a contract of sale of a commodity for future delivery.192 The final rule excludes from the definition of financial instrument: (i) A loan; 193 (ii) a commodity that is not an excluded commodity (other than foreign exchange or currency), a derivative, a contract of sale of a commodity for future delivery, or an option on a contract of sale of a commodity for future delivery; or (iii) foreign exchange or currency.194 An excluded commodity is defined to have the same meaning as in section 1a(19) of the Commodity Exchange Act. The Agencies continue to believe that these instruments and transactions, which are consistent with those referenced in section 13(h)(4) of the BHC Act as part of the statutory definition of proprietary trading, represent the type of financial instruments which the proprietary trading prohibition of section 13 was designed to cover. While some commenters requested that this definition be expanded to include spot transactions 195 or loans,196 the Agencies do not believe that it is appropriate at this time to expand the scope of instruments subject to the ban on proprietary trading.197 Similarly, while some commenters requested that certain other instruments, such as foreign exchange swaps and forwards, be excluded from the definition of financial instrument,198 the Agencies believe that these instruments appear to be, or operate in economic substance as, derivatives (which are by statute included within the scope of instruments subject to the prohibitions of section 13). If these instruments were not included within the definition of financial instrument, banking entities could use them to engage in proprietary trading that is inconsistent with the purpose and design of section 13 of the BHC Act. As under the proposal, loans, commodities, and foreign exchange or currency are not included within the scope of instruments subject to section
13. The exclusion of these types of
instruments is intended to eliminate potential confusion by making clear that the purchase and sale of loans, commodities, and foreign exchange or currency—none of which are referred to in section 13(h)(4) of the BHC Act—are outside the scope of transactions to which the proprietary trading restrictions apply. For example, the spot purchase of a commodity would meet the terms of the exclusion, but the acquisition of a futures position in the same commodity would not qualify for the exclusion. The final rule also adopts the definitions of security and derivative as proposed.199 These definitions, which reference existing definitions under the federal securities and commodities laws, are generally well-understood by market participants and have been subject to extensive interpretation in the context of securities and commodities trading activities. While some commenters argued that it would be inappropriate to use the definition of swap and security-based swap because those terms had not yet been finalized pursuant to public notice and comment,200 the CFTC and SEC have subsequently finalized those definitions after receiving extensive public comment on the rulemakings.201 The Agencies believe that this notice and comment process provided adequate opportunity for market participants to comment on and understand those terms, and as such they are incorporated in the definition of derivative under this final rule. While some commenters requested that foreign exchange swaps and forwards be excluded from the definition of derivative or financial instrument, the Agencies have not done so for the reasons discussed above. However, as explained below in Part IV.A.1.d., the Agencies note that to the extent a banking entity purchases or sells a foreign exchange forward or swap, or any other financial instrument, in a manner that meets an exclusion from proprietary trading, that transaction would not be considered to be proprietary trading and thus would not be subject to the requirements of
section 13 of the BHC Act and the final
rule. This includes, for instance, the purchase or sale of a financial instrument by a banking entity acting solely as agent, broker, or custodian, or the purchase or sale of a security as part of a bona fide liquidity management plan. d. Proprietary Trading Exclusions The proposed rule contained four exclusions from the definition of trading account for categories of transactions that do not fall within the scope of
section 13 of the BHC Act because they
do not involve short-term trading activities subject to the statutory prohibition on proprietary trading. These exclusions covered the purchase or sale of a financial instrument under certain repurchase and reverse repurchase agreements and securities lending arrangements, for bona fide

202See proposed rule §ll.3(b)(2)(iii)(A). 203See proposed rule § __.3(b)(2)(iii)(B). The language that described securities lending transactions in the proposed rule generally mirrored that contained in Rule 3a5–3 under the Exchange Act. See 17 CFR 240.3a5–3. 204See Joint Proposal, 76 FR 68,862. 205See generally ABA (Keating); Alfred Brock; Citigroup (Feb. 2012); GE (Feb. 2012); Goldman (Prop. Trading); ICBA; Japanese Bankers Ass’n.; JPMC; Norinchukin; RBC; RMA; SIFMA et al. (Prop. Trading) (Feb. 2012); State Street (Feb. 2012); T. Rowe Price; UBS; Wells Fargo (Prop. Trading). See infra Part IV.A.d.10. for the discussion of commenters’ requests for additional exclusions from the trading account. 206See SIFMA et al. (Prop.Trading) (Feb. 2012). 207See FIA; SIFMA et al. (Prop. Trading) (Feb. 2012). 208See Goldman (Prop. Trading); JPMC; UBS. 209See Goldman (Prop. Trading); UBS. For example, one commenter suggested that fully collateralized swap transactions should be exempted from the definition of trading account because they serve as funding transactions and are economically similar to repurchase agreements. See SIFMA et al. (Prop. Trading) (Feb. 2012). 210See Goldman (Prop. Trading). 211See AFR et al. (Feb. 2012); Occupy; Public Citizen; Sens. Merkley & Levin (Feb. 2012). 212See AFR et al. (Feb. 2012). 213See Public Citizen. 214See Public Citizen. 215See AFR et al. (Feb. 2012); Occupy. 216See AFR et al. (Feb. 2012); Occupy. liquidity management purposes, and by a clearing agency or derivatives clearing organization in connection with clearing activities. As discussed below, the final rule provides exclusions for the purchase or sale of a financial instrument under certain repurchase and reverse repurchase agreements and securities lending agreements; for bona fide liquidity management purposes; by certain clearing agencies, derivatives clearing organizations in connection with clearing activities; by a member of a clearing agency, derivatives clearing organization, or designated financial market utility engaged in excluded clearing activities; to satisfy existing delivery obligations; to satisfy an obligation of the banking entity in connection with a judicial, administrative, self-regulatory organization, or arbitration proceeding; solely as broker, agent, or custodian; through a deferred compensation or similar plan; and to satisfy a debt previously contracted. After considering comments on these issues, which are discussed in more detail below, the Agencies believe that providing clarifying exclusions for these nonproprietary activities will likely promote more cost-effective financial intermediation and robust capital formation. Overly narrow exclusions for these activities would potentially increase the cost of core banking services, while overly broad exclusions would increase the risk of allowing the types of trades the statute was designed to prohibit. The Agencies considered these issues in determining the appropriate scope of these
exclusions. Because the Agencies do not believe these excluded activities involve proprietary trading, as defined by the statute and the final rule, the Agencies do not believe it is necessary to use our exemptive authority in section 13(d)(1)(J) of the BHC Act to deem these activities a form of permitted proprietary trading.

Repurchase and Reverse Repurchase
Arrangements and Securities Lending The proposed rule’s definition of trading account excluded an account used to acquire or take one or more covered financial positions that arise under (i) a repurchase or reverse repurchase agreement pursuant to which the banking entity had simultaneously agreed, in writing at the start of the transaction, to both purchase and sell a stated asset, at stated prices, and on stated dates or on demand with the same counterparty,202 or (ii) a transaction in which the banking entity lends or borrows a security temporarily to or from another party pursuant to a written securities lending agreement under which the lender retains the economic interests of an owner of such security and has the right to terminate the transaction and to recall the loaned security on terms agreed to by the parties.203 Positions held under these agreements operate in economic substance as a secured loan and are not based on expected or anticipated movements in asset prices. Accordingly, these types of transactions do not appear to be of the type the statutory definition of trading account was designed to cover.204 Several commenters expressed support for these exclusions and requested that the Agencies expand them.205 For example, one commenter requested clarification that all types of repurchase transactions qualify for the exclusion.206 Some commenters requested expanding this exclusion to cover all positions financed by, or transactions related to, repurchase and reverse repurchase agreements.207 Other commenters requested that the exclusion apply to all transactions that are analogous to extensions of credit and are not based on expected or anticipated movements in asset prices, arguing that the exclusion would be too limited in scope to achieve its objective if it is based on the legal form of the underlying contract.208 Additionally, some commenters suggested expanding the exclusion to cover transactions that are for funding purposes, including prime brokerage transactions, or for the purpose of asset-liability management.209 Commenters also recommended expanding the exclusion to include re-hypothecation of customer securities, which can produce financing structures that, like a repurchase agreement, are functionally loans.210 In contrast, other commenters argued that there was no statutory or policy justification for excluding repurchase and reverse repurchase agreements from the trading account, and requested that this exclusion be removed from the final rule.211 Some of these commenters argued that repurchase agreements could be used for prohibited proprietary trading 212 and suggested that, if repurchase agreements are excluded from the trading account, documentation detailing the use of liquidity derived from repurchase agreements should be required.213 These commenters suggested that unless the liquidity is used to secure a position for a willing customer, repurchase agreements should be regarded as a strong indicator of
proprietary trading.214 As an alternative, commenters suggested that the Agencies instead use their exemptive authority pursuant to section 13(d)(1)(J) of the BHC Act to permit repurchase and reverse repurchase transactions so that such transactions must comply with the statutory limits on material conflicts of interests and high-risks assets and trading strategies, and compliance requirements under the final rule.215 These commenters urged the Agencies to specify permissible collateral types, haircuts, and contract terms for securities lending agreements and require that the investment of proceeds from securities lending transactions be limited to high-quality liquid assets in order to limit potential risks of these activities.216 After considering the comments received, the Agencies have determined to exclude repurchase and reverse repurchase agreements and securities lending agreements from the definition of proprietary trading under the final rule. The final rule defines these terms subject to the same conditions as were in the proposal. This determination recognizes that repurchase and reverse repurchase agreements and securities lending agreements excluded from the definition operate in economic substance as secured loans and do not in normal practice represent proprietary

217Congress recognized that repurchase agreements and securities lending agreements are loans or extensions of credit by including them in the legal lending limit. See Dodd–Frank Act section 610 (amending 12 U.S.C. 84b). The Agencies believe the conditions of the final rule’s exclusions for repurchase agreements and securities lending agreements identify those activities that do not in normal practice represent proprietary trading and, thus, the Agencies decline to provide additional requirements for these activities, as suggested by some commenters. See Public Citizen; AFR et al. (Feb. 2012); Occupy. 218See Goldman (Prop. Trading); JPMC; UBS. 219See CFTC Proposal, 77 FR 8348. 220See proposed rule §ll.3(b)(2)(iii)(C). 221 Id. 222See proposed rule §ll.3(b)(2)(iii)(C)(1)–(5). 223See Joint Proposal, 76 FR 68,862. 224See ABA (Keating); BoA; CH/ABASA; JPMC. See supra Part IV.A.1.b. (discussing the rebuttable presumption under §ll3.(b)(2) of the final rule); See also supra Part IV.A.1.a. (discussing the market risk rule trading account under §ll3.(b)(1)(ii) of the final rule). 225See CH/ABASA; Wells Fargo (Prop. Trading). 226See CH/ABASA; JPMC; State Street (Feb. 2012); Wells Fargo (Prop. Trading). See also BaFin/ Deutsche Bundesbank. 227See BoA; JPMC; RBC. 228See ABA (Keating); Allen & Overy (on behalf of Canadian Banks); JPMC; NAIB et al.; State Street (Feb. 2012); T. Rowe Price. 229See ABA (Keating); CH/ABASA; JPMC. 230See ABA (Keating); BoA; CH/ABASA; JPMC. 231See ABA (Keating); Allen & Overy (on behalf of Canadian Banks); BoA; CH/ABASA 232See T. Rowe Price. 233See State Street (Feb. 2012). 234See State Street (Feb. 2012); JPMC. See also
Part IV.A.1.d.10. (discussing commenter requests to
exclude inter-affiliate transactions). 235See AFR et al. (Feb. 2012); Occupy. 236See Occupy. 237See Sens. Merkley & Levin (Feb. 2012). trading.217 The Agencies will, however, monitor these transactions to ensure this exclusion is not used to engage in prohibited proprietary trading activities. To avoid evasion of the rule, the Agencies note that, in contrast to certain commenters’ requests,218 only the transactions pursuant to the repurchase agreement, reverse repurchase agreement, or securities lending agreement are excluded. For example, the collateral or position that is being financed by the repurchase or reverse repurchase agreement is not excluded and may involve proprietary trading. The Agencies further note that if a banking entity uses a repurchase or reverse repurchase agreement to finance a purchase of a financial instrument, other transactions involving that financial instrument may not qualify for this exclusion.219 Similarly, short positions resulting from securities lending agreements cannot rely upon this exclusion and may involve proprietary trading. Additionally, the Agencies have determined not to exclude all transactions, in whatever legal form that may be construed to be an extension of credit, as suggested by commenters, because such a broad exclusion would be too difficult to assess for compliance and would provide significant opportunity for evasion of the prohibitions in section 13 of the BHC Act.
2. Liquidity Management Activities
The proposed definition of trading account excluded an account used to acquire or take a position for the purpose of bona fide liquidity management, subject to certain requirements.220 The preamble to the proposed rule explained that bona fide liquidity management seeks to ensure that the banking entity has sufficient, readily-marketable assets available to meet its expected near-term liquidity needs, not to realize short-term profit or benefit from short-term price movements.221 To curb abuse, the proposed rule required that a banking entity acquire or take a position for liquidity management in accordance with a documented liquidity management plan that meets five criteria.222 Moreover, the Agencies stated in the preamble that liquidity management positions that give rise to appreciable profits or losses as a result of short-term price movements would be subject to significant Agency scrutiny and, absent compelling explanatory facts and circumstances, would be considered proprietary trading.223 The Agencies received a number of comments regarding the exclusion. Many commenters supported the exclusion of liquidity management activities from the definition of trading account as appropriate and necessary. At the same time, some commenters expressed the view that the exclusion was too narrow and should be replaced with a broader exclusion permitting trading activity for asset-liability management (‘‘ALM’’). Commenters argued that two aspects of the proposed rule’s definition of ‘‘trading account’’ would cause ALM transactions to fall within the prohibition on proprietary trading—the 60-day rebuttable presumption and the reference to the market risk rule trading account.224 For example, commenters expressed concern that hedging transactions associated with a banking entity’s residential mortgage pipeline and mortgage servicing rights, and managing credit risk, earnings at risk, capital, asset-liability mismatches, and foreign exchange risks would be among positions that may be held for 60 days or less.225 These commenters contended that the exclusion for liquidity management and the activity exemptions for risk-mitigating hedging and trading in U.S. government obligations would not be sufficient to permit a wide variety of ALM activities.226 These commenters contended that prohibiting trading for ALM purposes would be contrary to the goals of enhancing sound risk management, the safety and soundness of banking entities, and U.S. financial stability,227 and would limit banking entities’ ability to manage liquidity.228 Some commenters argued that the requirements of the exclusion would not provide a banking entity with sufficient flexibility to respond to liquidity needs arising from changing economic conditions.229 Some commenters argued the requirement that any position taken for liquidity management purposes be limited to the banking entity’s near-term funding needs failed to account for longer-term liquidity management requirements.230 These
commenters further argued that the requirements of the liquidity management exclusion might not be synchronized with the Basel III framework, particularly with respect to the liquidity coverage ratio if ‘‘near-term’’ is considered less than 30 days.231 Commenters also requested clarification on a number of other issues regarding the exclusion. For example, one commenter requested clarification that purchases and sales of U.S. registered mutual funds sponsored by a banking entity would be permissible.232 Another commenter requested clarification that the deposits resulting from providing custodial services that are invested largely in high-quality securities in conformance with the banking entity’s ALM policy would not be presumed to be ‘‘short-term trading’’ under the final rule.233 Commenters also urged that the final rule not prohibit interaffiliate transactions essential to the ALM function.234 In contrast, other commenters supported the liquidity management exclusion criteria 235 and suggested tightening these requirements. For example, one commenter recommended that the rule require that investments made under the liquidity management exclusion consist only of high-quality liquid assets.236 Other commenters argued that the exclusion for liquidity management should be eliminated.237 One commenter argued that there was no need to provide a special exemption for liquidity management or ALM activities given the exemptions for

238See Sens. Merkley & Levin (Feb. 2012). 239See section 165(b)(1)(A)(ii) of the Dodd-Frank Act; Enhanced Prudential Standards, 77 FR 644 at 645 (Jan. 5, 2012), available at http://www.gpo.gov/ fdsys/pkg/FR-2012-01-05/pdf/2011-33364.pdf; See also Enhanced Prudential Standards, 77 FR 76,678 at 76,682 (Dec. 28, 2012), available at http:// www.gpo.gov/fdsys/pkg/FR-2012-12-28/pdf/2012- 30734.pdf. 240To ensure sufficient flexibility to respond to liquidity needs arising from changing economic times, a banking entity should envision and address a range of liquidity circumstances in its liquidity management plan, and provide a mechanism for periodically reviewing and revising the liquidity management plan. 241The requirement to use highly liquid instruments is consistent with the focus of the clarifying exclusion on a banking entity’s near-term liquidity needs. Thus, the final rules do not include commenters’ suggested revisions to this requirement. See Clearing House Ass’n.; See also Occupy; Sens. Merkley & Levin (Feb. 2012). The Agencies decline to identify particular types of securities that will be considered highly liquid for purposes of the exclusion, as requested by some commenters, in recognition that such a determination will depend on the facts and circumstances. See T. Rowe Price; State Street (Feb. 2012). 242The Agencies plan to construe ‘‘near-term funding needs’’ in a manner that is consistent with the laws, regulations, and issuances related to liquidity risk management. See, e.g., Liquidity Coverage Ratio: Liquidity Risk Measurement, Standards, and Monitoring, 78 FR 71,818 (Nov. 29, 2013); Basel Committee on Bank Supervision, Basel III: The Liquidity Coverage Ratio and Liquidity Risk Management Tools (January 2013) available at http://www.bis.org/publ/bcbs238.htm. The Agencies believe this should help address commenters’ concerns about the proposed requirement. See, e.g., ABA (Keating); Allen & Overy (on behalf of Canadian Banks); CH/ABASA; BoA; JPMC. 243See, e.g., Staff of S. Comm. on Homeland Sec. & Governmental Affairs Permanent Subcomm. on Investigations, 113th Cong., Report: JPMorgan Chase Whale Trades: A Case History of Derivatives Risks and Abuses (Apr. 11, 2013), available at http://www.hsgac.senate.gov/download/reportjpmorgan-chase-whale-trades-a-case-history-ofderivatives-risks-and-abuses-march-15–2013. 244See, e.g., ABA (Keating); BoA; CH/ABASA; JPMC. trading in government obligations and risk-mitigating hedging activities.238 After carefully reviewing the comments received, the Agencies have adopted the proposed exclusion for liquidity management with several important modifications. As limited below, liquidity management activity serves the important prudential purpose, recognized in other provisions of the Dodd-Frank Act and in rules and guidance of the Agencies, of ensuring banking entities have sufficient liquidity to manage their short-term liquidity needs.239 To ensure that this exclusion is not misused for the
purpose of proprietary trading, the final rule imposes a number of requirements. First, the liquidity management plan of the banking entity must be limited to securities (in keeping with the liquidity management requirements proposed by the Federal banking agencies) and specifically contemplate and authorize the particular securities to be used for liquidity management purposes; describe the amount, types, and risks of securities that are consistent with the entity’s liquidity management; and the liquidity circumstances in which the particular securities may or must be used.240 Second, any purchase or sale of securities contemplated and authorized by the plan must be principally for the purpose of managing the liquidity of the banking entity, and not for the purpose of short-term resale, benefitting from actual or expected short-term price movements, realizing short-term arbitrage profits, or hedging a position taken for such short-term purposes. Third, the plan must require that any securities purchased or sold for liquidity management purposes be highly liquid and limited to instruments the market, credit and other risks of which the banking entity does not reasonably expect to give rise to appreciable profits or losses as a result of short-term price movements.241 Fourth, the plan must limit any securities purchased or sold for liquidity management purposes to an amount that is consistent with the banking entity’s near-term funding needs, including deviations from normal operations of the banking entity or any affiliate thereof, as estimated and documented pursuant to methods specified in the plan.242 Fifth, the banking entity must incorporate into its compliance program internal controls, analysis and independent testing designed to ensure that activities undertaken for liquidity management purposes are conducted in accordance with the requirements of the final rule and the entity’s liquidity management plan. Finally, the plan must be consistent with the supervisory requirements, guidance and expectations regarding liquidity management of the Agency responsible for regulating the banking entity. The final rule retains the provision that the financial instruments purchased and sold as part of a liquidity management plan be highly liquid and not reasonably expected to give rise to appreciable profits or losses as a result of short-term price movements. This requirement is consistent with the Agencies’ expectation for liquidity management plans in the supervisory context. It is not intended to prevent firms from recognizing profits (or losses) on instruments purchased and sold for liquidity management purposes. Instead, this requirement is intended to underscore that the purpose of these transactions must be liquidity management. Thus, the timing of purchases and sales, the types and duration of positions taken and the incentives provided to managers of these purchases and sales must all indicate that managing liquidity, and not taking
short-term profits (or limiting short-term losses), is the purpose of these activities. The exclusion as adopted does not apply to activities undertaken with the stated purpose or effect of hedging aggregate risks incurred by the banking entity or its affiliates related to assetliability mismatches or other general market risks to which the entity or affiliates may be exposed. Further, the exclusion does not apply to any trading activities that expose banking entities to substantial risk from fluctuations in market values, unrelated to the management of near-term funding needs, regardless of the stated purpose of the activities.243 Overall, the Agencies do not believe that the final rule will stand as an obstacle to or otherwise impair the ability of banking entities to manage the risks of their businesses and operate in a safe and sound manner. Banking entities engaging in bona fide liquidity management activities generally do not purchase or sell financial instruments for the purpose of short-term resale or to benefit from actual or expected shortterm price movements. The Agencies have determined, in contrast to certain commenters’ requests, not to expand this liquidity management provision to broadly allow asset-liability management, earnings management, or scenario hedging.244 To the extent these activities are for the purpose of profiting from short-term price movements or to hedge risks not related to short-term funding needs, they represent proprietary trading subject to section 13 of the BHC Act and the final rule; the activity would then be permissible only if it meets all of the requirements for an exemption, such as the risk-mitigating hedging exemption, the exemption for trading in U.S. government securities, or another exemption.
3. Transactions of Derivatives Clearing
Organizations and Clearing Agencies A banking entity that is a central counterparty for clearing and settlement activities engages in the purchase and sale of financial instruments as an integral part of clearing and settling those instruments. The proposed definition of trading account excluded an account used to acquire or take one or more covered financial positions by

245See proposed rule §ll.3(b)(2)(iii)(D). 246See Joint Proposal, 76 FR 68,863. 247See Allen & Overy (Clearing); Goldman (Prop. Trading); SIFMA et al. (Prop. Trading) (Feb. 2012); State Street (Feb. 2012). 248See IIB/EBF. 249See Sens. Merkley & Levin (Feb. 2012). 250 ‘‘Clearing agency’’ is defined in the final rule with reference to the definition of this term in the Exchange Act. See final rule §ll.3(e)(2). ‘‘Derivatives clearing organization’’ is defined in the final rule as (i) a derivatives clearing organization registered under section 5b of the Commodity Exchange Act; (ii) a derivatives clearing organization that, pursuant to CFTC regulation, is exempt from the registration requirements under
section 5b of the Commodity Exchange Act; or (iii)
a foreign derivatives clearing organization that, pursuant to CFTC regulation, is permitted to clear for a foreign board of trade that is registered with the CFTC. 251See IIB/EBF; BNY Mellon et al.; SIFMA et al. (Prop.Trading) (Feb. 2012); Allen & Overy (Clearing); Goldman (Prop. Trading). 252See IIB/EBF; Allen & Overy (Clearing). 253See SIFMA et al. (Prop. Trading) (Feb. 2012); Allen & Overy (Clearing); Goldman (Prop. Trading); State Street (Feb. 2012). 254See proposed rule §ll.3(b)(2)(iii)(D). 255See SIFMA et al. (Prop. Trading) (Feb. 2012); Allen & Overy (Clearing); Goldman (Prop. Trading); State Street (Feb. 2012). 256See SIFMA et al. (Prop. Trading) (Feb. 2012); Allen & Overy (Clearing); State Street (Feb. 2012). See also ISDA (Feb. 2012). 257See SIFMA et al. (Prop. Trading) (Feb. 2012); Allen & Overy (Clearing). 258See Allen & Overy (Clearing). 259See SIFMA et al. (Prop. Trading) (Feb. 2012). 260See SIFMA et al. (Prop. Trading) (Feb. 2012) (arguing that the SEC has suggested that entities that collect margins from customers for cleared swaps may be required to be registered as brokerdealers); State Street (Feb. 2012). 261See Goldman (Prop. Trading); SIFMA et al. (Prop.Trading) (Feb. 2012); ISDA (Feb. 2012). 262See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); State Street (Feb. 2012); Allen & Overy (Clearing). 263See Allen & Overy (Clearing). a derivatives clearing organization registered under the Commodity Exchange Act or a clearing agency registered under the Securities Exchange Act of 1934 in connection with clearing derivatives or securities transactions.245 The preamble to the proposed rule noted that the purpose of these transactions is to provide a clearing service to third parties, not to profit from short-term resale or shortterm price movements.246 Several commenters supported the proposed exclusion for derivatives clearing organizations and urged the Agencies to expand the exclusion to cover a banking entity’s clearing-related activities, such as clearing a trade for a customer, trading with a clearinghouse, or accepting positions of a defaulting member, on grounds that these activities are not proprietary trades and reduce systemic risk.247 One commenter recommended expanding the exclusion to non-U.S. central counterparties 248 In contrast, one commenter argued that the exclusion for derivatives clearing organizations and clearing agencies had no statutory basis and should instead be a permitted activity under section 13(d)(1)(J).249 After considering the comments received, the final rule retains the exclusion for purchases and sales of financial instruments by a banking entity that is a clearing agency or derivatives clearing organization in connection with its clearing activities.250 In response to comments,251 the Agencies have also incorporated two changes to the rule. First, the final rule applies the exclusion to the purchase and sale of financial instruments by a banking entity that is a clearing
agency or derivatives clearing organization in connection with clearing financial instrument transactions. Second, in response to comments,252 the exclusion in the final rule is not limited to clearing agencies or derivatives clearing organizations that are subject to SEC or CFTC registration requirements and, instead, certain foreign clearing agencies and foreign derivatives clearing organizations will be permitted to rely on the exclusion if they are banking entities. The Agencies believe that clearing and settlement activity is not designed to create short-term trading profits. Moreover, excluding clearing and settlement activities prevents the final rule from inadvertently hindering the Dodd–Frank Act’s goal of promoting central clearing of financial transactions. The Agencies have narrowly tailored this exclusion by allowing only central counterparties to use it and only with respect to their clearing and settlement activity.
4. Excluded Clearing-Related Activities
of Clearinghouse Members
In addition to the exclusion for trading activities of a derivatives clearing organization or clearing agency, some commenters requested an additional exclusion from the definition of ‘‘trading account’’ for clearing-related activities of members of these entities.253 These commenters noted that the proposed definition of ‘‘trading account’’ provides an exclusion for positions taken by registered derivatives clearing organizations and registered clearing agencies 254 and requested a corresponding exclusion for certain clearing-related activities of banking entities that are members of a clearing agency or members of a derivatives clearing organization (collectively, ‘‘clearing members’’).255 Several commenters argued that certain aspects of the clearing process may require a clearing member to engage in principal transactions. For example, some commenters argued that a clearinghouse’s default management process may require clearing members to take positions in financial instruments upon default of another clearing member.256 According to commenters, default management processes can involve: (i) Collection of initial and variation margin from customers under an ‘‘agency model’’ of clearing; (ii) porting, where a defaulting clearing member’s customer positions and margin are transferred to another non-defaulting clearing member; 257 (iii) hedging, where the clearing house looks to clearing members and third parties to enter into risk-reducing transactions and to flatten the market risk associated with the defaulting clearing member’s house positions and non-ported customer positions; (iv) unwinding, where the defaulting member’s open positions may be allocated to other clearing members, affiliates, or third parties pursuant to a mandatory auction process or forced allocation; 258 and (v) imposing certain obligations on clearing members upon exhaustion of a guaranty fund.259 Commenters argued that, absent an exclusion from the definition of ‘‘trading account,’’ some of these clearing-related activities could be considered prohibited proprietary trading under the proposal. Two commenters specifically contended that the dealer prong of the definition of ‘‘trading account’’ may cause certain of these activities to be considered proprietary trading.260 Some commenters suggested alternative avenues for permitting such clearingrelated activity under the rules.261 Commenters argued that such clearingrelated activities of banking entities should not be subject to the rule because they are risk-reducing, beneficial for the financial system, required by law under certain circumstances (e.g., central clearing requirements for swaps and security-based swaps under Title VII of the Dodd-Frank Act), and not used by banking entities to engage in proprietary trading.262 Commenters further argued that certain activities undertaken as part of a clearing house’s daily risk management process may be impacted by the rule, including unwinding selfreferencing
transactions through a mandatory auction (e.g., where a firm acquired credit default swap (‘‘CDS’’) protection on itself as a result of a merger with another firm) 263 and trade crossing, a mechanism employed by

264See Allen & Overy (Clearing); SIFMA et al. (Prop.Trading) (Feb. 2012). These commenters stated that, in order to ensure that a clearing member is providing accurate end-of-day prices for its open positions, a clearing house may require the member to provide firm bids for such positions, which may be tested through a ‘‘forced trade’’ with another member. See id.; See also ISDA (Feb. 2012). 265For example, Title VII of the Dodd-Frank Act mandates the central clearing of swaps and security-based swaps, and requires that banking entities that are swap dealers, security-based swap dealers, major swap participants or major securitybased swap participants collect variation margin from many counterparties on a daily basis for their swap or security-based swap activity. See 7 U.S.C. 2(h); 15 U.S.C. 78c–3; 7 U.S.C. 6s(e); 15 U.S.C. 78o– 10(e); Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 76 FR 23,732 (Apr. 28, 2011). Additionally, the SEC’s Rule 17Ad–22(d)(11) requires that each registered clearing agency establish, implement, maintain and enforce policies and procedures that set forth the clearing agency’s default management procedures. See 17 CFR 240.17Ad–22(d)(11). See also Exchange Act Release No. 68,080 (Oct. 12, 2012), 77 FR 66,220, 66,283 (Nov. 2, 2012). 266Centralized clearing affects counterparty risk in three basic ways. First, it redistributes counterparty risk among members through mutualization of losses, reducing the likelihood of sequential counterparty failure and contagion. Second, margin requirements and monitoring reduce moral hazard, reducing counterparty risk. Finally, clearing may reallocate counterparty risk outside of the clearing agency because netting may implicitly subordinate outside creditors’ claims relative to other clearing member claims. 267See Proposed Rule, Cross-Border SecurityBased Swap Activities, Exchange Act Release No. 69490 (May 1, 2013), 78 FR 30,968, 31,162–31,163 (May 23, 2013). 268See final rule §ll.3(d)(5). 269See final rule §ll.3(e)(7). 270A number of commenters discussed the default management process and requested an exclusion for such activities. See SIFMA et al. (Prop. Trading) (Feb. 2012); Allen & Overy (Clearing); State Street (Feb. 2012). See also ISDA (Feb. 2012). 271See Allen & Overy (Clearing) (discussing rules that require unwinding self-referencing transactions through a mandatory auction (e.g., where a firm acquired CDS protection on itself as a result of a merger with another firm)). 272See Allen & Overy (Clearing); SIFMA et al. (Prop. Trading) (Feb. 2012); See also ISDA (Feb. 2012). 273See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading). 274 In order to qualify for this exclusion, a banking entity’s principal trading activity that results in its own failure to deliver must have been conducted in compliance with these rules. 275See, e.g., 17 CFR 242.204 (requiring, among other things, that a participant of a registered clearing
agency or, upon reasonable allocation, a broker-dealer for which the participant clears trades or from which the participant receives trades for settlement, take action to close out a fail to deliver position in any equity security by borrowing or purchasing securities of like kind and quantity); 17 CFR 240.15c3–3(m) (providing that, if a brokerdealer executes a sell order of a customer and does not obtain possession of the securities from the customer within 10 business days after settlement, the broker-dealer must immediately close the transaction with the customer by purchasing securities of like kind and quantity). certain clearing houses to ensure the accuracy of the price discovery process in the course of, among other things, calculating settlement prices and margin requirements.264 The Agencies do not believe that certain core clearing-related activities conducted by a clearing member, often as required by regulation or the rules and procedures of a clearing agency, derivatives clearing organization, or designated financial market utility, represent proprietary trading as contemplated by the statute. For example, the clearing and settlement activities discussed above are not conducted for the purpose of profiting from short-term price movements. The Agencies believe that these clearingrelated activities provide important benefits to the financial system.265 In particular, central clearing reduces counterparty credit risk,266 which can lead to a host of other benefits, including lower hedging costs, increased market participation, greater liquidity, more efficient risk sharing that promotes capital formation, and reduced operational risk.267 Accordingly, in response to comments, the final rule provides that proprietary trading does not include specified excluded clearing activities by a banking entity that is a member of a clearing agency, a member of a derivatives clearing organization, or a member of a designated financial market utility.268 ‘‘Excluded clearing activities’’ is defined in the rule to identify particular core clearing-related activities, many of which were raised by commenters.269 Specifically, the final rule will exclude the following activities by clearing members: (i) Any purchase or sale necessary to correct error trades made by or on behalf of customers with respect to customer transactions that are cleared, provided the purchase or sale is conducted in accordance with certain regulations, rules, or procedures; (ii) any purchase or sale related to the management of a default or threatened imminent default of a customer, subject to certain conditions, another clearing member, or the clearing agency, derivatives clearing organization, or designated financial market utility itself; 270 and (iii) any purchase or sale required by the rules or procedures of a clearing agency, derivatives clearing organization, or designated financial market utility that mitigates risk to such agency, organization, or utility that would
result from the clearing by a clearing member of security-based swaps that references the member or an affiliate of the member.271 The Agencies are identifying specific activities in the rule to limit the potential for evasion that may arise from a more generalized approach. However, the relevant supervisory Agencies will be prepared to provide further guidance or relief, if appropriate, to ensure that the terms of the exclusion do not limit the ability of clearing agencies, derivatives clearing organizations, or designated financial market utilities to effectively manage their risks in accordance with their rules and procedures. In response to commenters requesting that the exclusion be available when a clearing member is required by rules of a clearing agency, derivatives clearing organization, or designated financial market utility to purchase or sell a financial instrument as part of establishing accurate prices to be used by the clearing agency, derivatives clearing organization, or designated financial market utility in its end of day settlement process,272 the Agencies note that whether this is an excluded clearing activity depends on the facts and circumstances. Similarly, the availability of other exemptions to the rule, such as the market-making exemption, depend on the facts and circumstances. This exclusion applies only to excluded clearing activities of clearing members. It does not permit a banking entity to engage in proprietary trading and claim protection for that activity because trades are cleared or settled through a central counterparty.
5. Satisfying an Existing Delivery
Obligation
A few commenters requested additional or expanded exclusions from the definition of ‘‘trading account’’ for covering short sales or failures to deliver.273 These commenters alleged that a banking entity engages in this activity for purposes other than to benefit from short term price movements and that it is not proprietary trading as defined in the statute. In response to these comments, the final rule provides that a purchase or sale by a banking entity that satisfies an existing delivery obligation of the banking entity or its customers, including to prevent or close out a failure to deliver, in connection with delivery, clearing, or settlement activity is not proprietary trading. Among other things, this exclusion will allow a banking entity that is an SEC-registered broker-dealer to take action to address failures to deliver arising from its own trading activity or the trading activity of its customers.274 In certain circumstances, SEC-registered broker-dealers are required to take such action under SEC rules.275 In addition, buy-in procedures of a clearing agency, securities exchange, or national securities association may require a

276See, e.g., NSCC Rule 11, NASDAQ Rule 11810, FINRA Rule 11810. 277See, e.g., 17 CFR 242.204 (requiring action to close out a fail to deliver position in an equity security within certain specified timeframes); 17 CFR 240.15c3–3(m) (requiring a broker-dealer to ‘‘immediately’’ close a transaction under certain circumstances). 278For example, an administrative agency or SRO may require a broker-dealer to offer to buy securities back from customers where the agency or SRO finds the broker-dealer fraudulently sold securities to those customers. See, e.g., In re Raymond James & Assocs., Exchange Act Release No. 64767, 101 S.E.C. Docket 1749 (June 29, 2011); FINRA Dep’t of Enforcement v. Pinnacle Partners Fin. Corp., Disciplinary Proceeding No. 2010021324501 (Apr. 25, 2012); FINRA Dep’t of Enforcement v. Fifth Third Sec., Inc., No. 2005002244101 (Press Rel. Apr. 14, 2009). 279For instance, section 29 of the Exchange Act may require a broker-dealer to rescind a contract with a customer that was made in violation of the Exchange Act. Such rescission relief may involve the broker-dealer’s repurchase of a financial instrument from a customer. See 15 U.S.C. 78cc; Reg’l Props., Inc. v. Fin. & Real Estate Consulting Co., 678 F.2d 552 (5th Cir. 1982); Freeman v. Marine Midland Bank N.Y., 419 F.Supp. 440 (E.D.N.Y. 1976). 280See proposed rule §ll.3(b)(1). 281See Japanese Bankers Ass’n. 282See 12 U.S.C. 1851(h)(4). A common or collective investment fund that is an investment company under section 3(c)(3) or 3(c)(11) will not be deemed to be acting as principal within the meaning of §ll.3(a) because the fund is performing a traditional trust activity and purchases and sells financial instruments solely on behalf of customers as trustee or in a similar fiduciary capacity, as evidenced by its regulation under 12 CFR part 9 (Fiduciary Activities of National Banks) or similar state laws. 283See Ass’n. of Institutional Investors (Nov. 2012). 284See LSTA (Feb. 2012); JPMC; Goldman (Prop. Trading); SIFMA et al. (Prop.Trading) (Feb. 2012). banking entity to deliver securities if a party with a fail to receive position takes certain action.276 When a banking entity purchases securities to meet an existing delivery obligation, it is engaging in activity that facilitates timely settlement of securities transactions and helps provide a purchaser of the securities with the benefits of ownership (e.g., voting and lending rights). In addition, a banking entity has limited discretion to determine when and how to take action to meet an existing delivery obligation.277 Providing a limited exclusion for this activity will avoid the potential for SEC-registered brokerdealers being subject to conflicting or inconsistent regulatory requirements with respect to activity required to meet the broker-dealer’s existing delivery obligations.
6. Satisfying an Obligation in
Connection With a Judicial, Administrative, Self-Regulatory Organization, or Arbitration Proceeding The Agencies recognize that, under certain circumstances, a banking entity may be required to purchase or sell a financial instrument at the direction of a judicial or regulatory body. For example, an administrative agency or self-regulatory organization (‘‘SRO’’) may require a banking entity to purchase or sell a financial instrument in the course of disciplinary proceedings against that banking entity.278 A banking entity may also be obligated to purchase or sell a financial instrument in connection with a judicial or arbitration proceeding.279 Such transactions do not represent trading for short-term profit or gain and do not constitute proprietary trading under the statute. Accordingly, the Agencies have determined to adopt a provision clarifying that a purchase or sale of one or more financial instruments that satisfies an obligation of the banking entity in connection with a judicial, administrative, self-regulatory organization, or arbitration proceeding is not proprietary trading for purposes of these rules. This clarification will avoid the potential for conflicting or inconsistent legal requirements for banking entities.
7. Acting Solely as Agent, Broker, or
Custodian
The proposal clarified that proprietary trading did not include acting solely as agent, broker, or custodian for an unaffiliated third party.280 Commenters generally supported this aspect of the proposal. One commenter suggested that acting as agent, broker, or custodian for affiliates should be explicitly excluded from the definition of proprietary trading in the same manner as acting as agent, broker, or custodian for unaffiliated third parties.281 Like the proposal, the final rule expressly provides that the purchase or sale of one or more financial instruments by a banking entity acting solely as agent, broker, or custodian is not proprietary trading because acting in these types of capacities does not involve trading as principal, which is one of the requisite aspects of the statutory definition of proprietary trading.282 The final rule has been modified to include acting solely as agent, broker, or custodian on behalf of an affiliate. However, the affiliate must comply with section 13 of the BHC Act and the final implementing rule; and may not itself engage in prohibited proprietary trading. To the extent a banking entity acts in both a principal and agency capacity for a purchase or sale, it may only use this exclusion for the portion of the purchase or sale for which it is acting as agent. The banking entity must use a separate exemption or exclusion, if applicable, to the extent it is acting in a principal capacity.
8. Purchases or Sales Through a
Deferred Compensation or Similar Plan While the proposed rule provided that the prohibition on covered fund activities and investments did not apply to certain instances where the banking entity acted through or on behalf of a pension or similar deferred compensation plan, no such similar treatment was given for proprietary trading. One commenter argued that the proposal restricted a banking entity’s ability to engage in principal-based trading as an asset manager that serves the needs of the institutional investors, such as through ERISA pension and 401(k) plans.283 To address these concerns, the final rule provides that proprietary trading does not include the purchase or sale of one or more financial instruments through a deferred compensation, stockbonus, profit-sharing, or pension plan of the banking entity that is established and administered in accordance with the laws of the United States or a foreign sovereign, if the purchase or sale is made directly or indirectly by the banking entity as trustee for the benefit of the employees of the banking entity or members of their immediate family. Banking entities often establish and act as trustee to pension or similar deferred compensation plans for their employees and, as part of managing these plans, may engage in trading activity. The Agencies believe that purchases or sales by a banking entity when acting through pension and similar deferred compensation plans generally occur on behalf of beneficiaries of the plan and consequently do not constitute the type of principal trading that is covered by the statute. The Agencies note that if a banking entity engages in trading activity for an unaffiliated pension or similar deferred compensation plan, the trading activity of the banking entity would not be proprietary trading under the final rule to the extent the banking entity was acting solely as agent, broker, or custodian.
9. Collecting a Debt Previously
Contracted
Several commenters argued that the final rule should exclude collecting and disposing of collateral in satisfaction of debts previously contracted from the definition of proprietary trading.284 Commenters argued that acquiring and

285See final rule §ll.3(d)(9).
286For example, if any margin call is not met in full within the time required by Regulation T, then Regulation T requires a broker-dealer to liquidate securities sufficient to meet the margin call or to eliminate any margin deficiency existing on the day such liquidation is required, whichever is less. See 12 CFR 220.4(d). 287See SEC Proposed Rule, Capital, Margin, Segregation, Reporting and Recordkeeping Requirements for Security-Based Swap Dealers, Exchange Act Release No. 68071, 77 FR 70,214 (Nov. 23, 2012); CFTC Proposed Rule, Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 76 FR 23,732 (Apr. 28, 2011); Banking Agencies’ Proposed Rule, Margin and Capital Requirements for Covered Swap Entities, 76 FR 27,564 (May 11, 2011). 288See, e.g., SIFMA et al. (Prop. Trading) (Feb.
2012) (transactions that are not based on expected
or anticipated movements in asset prices, such as fully collateralized swap transactions that serve funding purposes); Norinchukin and Wells Fargo (Prop. Trading) (derivatives that qualify for hedge accounting); GE (Feb. 2012) (transactions related to commercial contracts); Citigroup (Feb. 2012) (FX swaps and FX forwards); SIFMA et al. (Prop. Trading) (Feb. 2012) (interaffiliate transactions); T. Rowe Price (purchase and sale of shares in sponsored mutual funds); RMA (cash collateral pools); Alfred Brock (arbitrage trading); ICBA (securities traded pursuant to 12 U.S.C. 1831a(f)). The Agencies are concerned that these exclusions could be used to conduct impermissible proprietary trading, and the Agencies believe some of these exclusions are more appropriately addressed by other provisions of the rule. For example, derivatives qualifying for hedge accounting may be permitted under the hedging exemption. 289 12 U.S.C. 1851(d)(1)(B). 290See proposed rule §ll.4(a). disposing of collateral in satisfaction of debt previously contracted does not involve trading with the intent of profiting from short-term price movements and, thus, should not be proprietary trading for purposes of this rule. Rather, this activity is a prudent and desirable part of lending and debt collection activities. The Agencies believe that the purchase and sale of a financial instrument in satisfaction of a debt previously contracted does not constitute proprietary trading. The Agencies believe an exclusion for purchases and sales in satisfaction of debts previously contracted is necessary for banking entities to continue to lend to customers, because it allows banking entities to continue lending activity with the knowledge that they will not be penalized for recouping losses should a customer default. Accordingly, the final rule provides that proprietary trading does not include the purchase or sale of one or more financial instruments in the ordinary course of collecting a debt previously contracted in good faith, provided that the banking entity divests the financial instrument as soon as practicable within the time period permitted or required by the appropriate financial supervisory agency.285 As a result of this exclusion, banking entities, including SEC-registered broker-dealers, will be able to continue providing margin loans to their customers and may take possession of margined collateral following a customer’s default or failure to meet a margin call under applicable regulatory requirements.286 Similarly, a banking entity that is a CFTC-registered swap dealer or SEC-registered security-based swap dealer may take, hold, and exchange any margin collateral as counterparty to a cleared or uncleared swap or security-based swap transaction, in accordance with the rules of the Agencies.287 This exclusion will allow banking entities to comply with existing regulatory requirements regarding the divestiture of collateral taken in satisfaction of a debt.
10. Other Requested Exclusions
Commenters requested a number of additional exclusions from the trading account and, in turn, the prohibition on proprietary trading. In order to avoid potential evasion of the final rule, the Agencies decline to adopt any exclusions from the trading account other than the exclusions described above.288 The Agencies believe that various modifications to the final rule, including in particular to the exemption for market-making related activities, address many of commenters’ concerns regarding unintended consequences of the prohibition on proprietary trading.
2. Section ll.4(a): Underwriting
Exemption a. Introduction After carefully considering comments on the proposed underwriting exemption, the Agencies are adopting the proposed underwriting exemption substantially as proposed, but with certain refinements and clarifications to the proposed approach to better reflect the range of securities offerings that an underwriter may help facilitate on behalf of an issuer or selling security holder and the types of activities an underwriter may undertake in connection with a distribution of securities to facilitate the distribution process and provide important benefits to issuers, selling security holders, or purchasers in the distribution. The Agencies are adopting such an approach because the statute specifically permits banking entities to continue providing these beneficial services to clients, customers, and counterparties. At the same time, to reduce the potential for evasion of the general prohibition on proprietary trading, the Agencies are requiring, among other things, that the trading desk make reasonable efforts to sell or otherwise reduce its underwriting position (accounting for the liquidity, maturity, and depth of the market for the relevant type of security) and be subject to a robust risk limit structure that is designed to prevent a trading desk from having an underwriting position that exceeds the reasonably expected near term demands of clients, customers, or counterparties. b. Overview

Proposed Underwriting Exemption
Section 13(d)(1)(B) of the BHC Act
provides an exemption from the prohibition on proprietary trading for the purchase, sale, acquisition, or disposition of securities and certain other instruments in connection with underwriting activities, to the extent that such activities are designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties.289
Section ll.4(a) of the proposed rule
would have implemented this exemption by requiring that a banking entity’s underwriting activities comply with seven requirements. As discussed in more detail below, the proposed underwriting exemption required that:
(i) A banking entity establish a compliance program under §ll.20; (ii) the covered financial position be a security; (iii) the purchase or sale be effected solely in connection with a distribution of securities for which the banking entity is acting as underwriter; (iv) the banking entity meet certain dealer registration requirements, where applicable; (v) the underwriting activities be designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties; (vi) the underwriting activities be designed to generate revenues primarily from fees, commissions, underwriting spreads, or other income not attributable to appreciation in the value of covered financial positions or to hedging of covered financial positions; and (vii) the compensation arrangements of persons performing underwriting activities be designed not to reward proprietary risktaking.290 The proposal explained that these seven criteria were proposed so that any banking entity relying on the underwriting exemption would be engaged in bona fide underwriting activities and would conduct those activities in a way that would not be susceptible to abuse through the taking of speculative, proprietary positions as

291See Joint Proposal, 76 FR 68,866; CFTC Proposal, 77 FR 8352. 292See Barclays (stating that the proposed exemption generally effectuates the aims of the statute while largely avoiding undue interference, although the commenter also requested certain technical changes to the rule text); Alfred Brock. 293See, e.g., Lord Abbett; BoA; Fidelity; Chamber (Feb. 2012). 294See Sens. Merkley & Levin (Feb. 2012); BoA; Fidelity; Occupy; AFR et al. (Feb. 2012). 295See Sens. Merkley & Levin (Feb. 2012) (suggesting a safe harbor for underwriting efforts that meet certain low-risk criteria, including that:
The underwriting be in plain vanilla stock or bond offerings, including commercial paper, for established business and governments; and the distribution be completed within relevant time periods, as determined by asset classes, with relevant factors being the size of the issuer and the market served); Johnson & Prof. Stiglitz (expressing support for a narrow safe harbor for underwriting of basic stocks and bonds that raise capital for real economy firms). 296See Sens. Merkley & Levin (Feb. 2012) (suggesting that, for example, the exemption plainly prevent high-risk, conflict ridden underwritings of securitizations and structured products and crossreference Section 621 of the Dodd-Frank Act, which prohibits certain material conflicts of interest in connection with asset-backed securities). 297See AFR et al. (Feb. 2012) (recommending that the Agencies prohibit banking entities from acting as underwriter for assets classified as Level 3 under FAS 157, which would prohibit underwriting of illiquid and opaque securities without a genuine external market, and representing that such a restriction would be consistent with the statutory limitation on exposures to high-risk assets). 298See Occupy. 299See BoA (recommending that the Agencies establish a strong presumption that all of a banking entity’s activities related to underwriting are permitted under the rules as long as the banking entity has adequate compliance and risk management procedures). 300See Fidelity (suggested that the rules be revised to ‘‘provide the broadest exemptions possible under the statute’’ for underwriting and certain other permitted activities). 301See infra Part IV.A.2.c.1.c. 302See infra Part IV.A.2.c.1.c. The term ‘‘trading desk’’ is defined in final rule §ll.3(e)(13) as ‘‘the smallest discrete unit of organization of a banking entity that purchases or sells financial instruments for the trading account of the banking entity or an affiliate thereof.’’ 303See final rule §§ll.4(a)(2)(i), ll.4(a)(3), ll.4(a)(4); See also infra Part IV.A.2.c.1.c. 304See final rule §ll.4(a)(2)(ii); See also infra
Part IV.A.2.c.2.c.
part of, or mischaracterized as,
underwriting activity.291
2. Comments on Proposed Underwriting
Exemption
As a general matter, a few commenters expressed overall support for the proposed underwriting exemption.292 Some commenters indicated that the proposed exemption is too narrow and may negatively impact capital markets.293 As discussed in more detail below, many commenters expressed views on the effectiveness of specific requirements of the proposed exemption. Further, some commenters requested clarification or expansion of the proposed exemption for certain activities that may be conducted in the course of underwriting. Several commenters suggested alternative approaches to implementing the statutory exemption for underwriting activities.294 More specifically, commenters recommended that the Agencies: (i) Provide a safe harbor for low risk, standard underwritings; 295 (ii) better incorporate the statutory limitations on high-risk activity or conflicts of interest; 296 (iii) prohibit banking entities from underwriting illiquid securities; 297 (iv) prohibit banking entities from participating in private placements; 298 (v) place greater emphasis on adequate internal compliance and risk management procedures; 299 or (vi) make the exemption as broad as possible.300
3. Final Underwriting Exemption
After considering the comments received, the Agencies are adopting the underwriting exemption substantially as proposed, but with important modifications to clarify provisions or to address commenters’ concerns. As discussed above, some commenters were generally supportive of the proposed approach to implementing the underwriting exemption, but noted certain areas of concern or uncertainty. The underwriting exemption the Agencies are adopting addresses these issues by further clarifying the scope of activities that qualify for the exemption. In particular, the Agencies are refining the proposed exemption to better capture the broad range of capitalraising activities facilitated by banking entities acting as underwriters on behalf of issuers and selling security holders. The final underwriting exemption includes the following components:

A framework that recognizes the
differences in underwriting activities across markets and asset classes by establishing criteria that will be applied flexibly based on the liquidity, maturity, and depth of the market for the particular type of security.
A general focus on the
‘‘underwriting position’’ held by a banking entity or its affiliate, and managed by a particular trading desk, in connection with the distribution of securities for which such banking entity or affiliate is acting as an underwriter.301
A definition of the term ‘‘trading
desk’’ that focuses on the functionality of the desk rather than its legal status, and requirements that apply at the trading desk level of organization within a banking entity or across two or more affiliates.302
Five standards for determining
whether a banking entity is engaged in permitted underwriting activities. Many of these criteria have similarities to those included in the proposed rule, but with important modifications in response to comments. These standards require that:
Æ The banking entity act as an ‘‘underwriter’’ for a ‘‘distribution’’ of securities and the trading desk’s underwriting position be related to such distribution. The final rule includes refined definitions of ‘‘distribution’’ and ‘‘underwriter’’ to better capture the broad scope of securities offerings used by issuers and selling security holders and the range of roles that a banking entity may play as intermediary in such offerings.303 Æ The amount and types of securities in the trading desk’s underwriting position be designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties, and reasonable efforts be made to sell or otherwise reduce the underwriting position within a reasonable period, taking into account the liquidity, maturity, and depth of the market for the relevant type of security.304 Æ The banking entity establish, implement, maintain, and enforce an internal compliance program that is reasonably designed to ensure the banking entity’s compliance with the requirements of the underwriting exemption, including reasonably designed written policies and procedures, internal controls, analysis, and independent testing identifying and addressing:
D The products, instruments, or exposures each trading desk may purchase, sell, or manage as part of its underwriting activities; D Limits for each trading desk, based on the nature and amount of the trading desk’s underwriting activities, including the reasonably expected near term demands of clients, customers, or counterparties, on the amount, types, and risk of the trading desk’s underwriting position, level of exposures to relevant risk factors arising from the trading desk’s underwriting position, and period of time a security may be held; D Internal controls and ongoing monitoring and analysis of each trading desk’s compliance with its limits; and D Authorization procedures, including escalation procedures that require review and approval of any trade that would exceed a trading desk’s limit(s), demonstrable analysis of the basis for any temporary or permanent

305See final rule §ll.4(a)(2)(iii); See also infra
Part IV.A.2.c.3.c.
306See final rule §ll.4(a)(2)(iv); See also infra
Part IV.A.2.c.4.c.
307See final rule §ll.4(a)(2)(v); See also infra
Part IV.A.2.c.5.c.
308See Sens. Merkley & Levin (Feb. 2012); Johnson & Prof. Stiglitz. One of these commenters also suggested that the Agencies better incorporate the statutory limitations on material conflicts of interest and high-risk activities in the underwriting exemption by including additional provisions in the exemption to refer to these limitations. See Sens. Merkley & Levin (Feb. 2012). The Agencies note that these limitations are adopted in §ll.7 of the final rules, and this provision will apply to underwriting activities, as well as all other exempted activities. 309See final rule §ll.4(a)(3). 310See AFR et al. (Feb. 2012). 311See Joint Proposal, 76 FR 68,859 n.101 (explaining why the Agencies declined to incorporate certain accounting standards in the proposed rule); CFTC Proposal, 77 FR 8344 n.107. 312See infra Part IV.A.2.c.2.c. 313See BoA. 314See Fidelity. 315See, e.g., BoA (‘‘The underwriting activities of U.S. banking entities are essential to capital formation and, therefore, economic growth and job creation.’’); Goldman (Prop. Trading); Sens. Merkley & Levin (Feb. 2012). 316See proposed rule §ll.4(a)(2)(iii). 317See proposed rule §ll.4(a)(2)(ii). 318See Joint Proposal, 76 FR 68,866–68,867; CFTC Proposal, 77 FR 8352; 17 CFR 242.101; proposed rule §ll.4(a)(3). 319See proposed rule §ll.4(a)(3). 320See Joint Proposal, 76 FR 68,867 (‘‘For example, the number of shares to be sold, the percentage of the outstanding shares, public float, and trading volume that those shares represent are all relevant to an assessment of magnitude. In Continued increase to a trading desk’s limit(s), and independent review of such demonstrable analysis and approval.305 Æ The compensation arrangements of persons performing the banking entity’s underwriting activities are designed not to reward or incentivize prohibited proprietary trading.306 Æ The banking entity is licensed or registered to engage in the activity described in the underwriting exemption in accordance with applicable law.307 After considering commenters’ suggested alternative approaches to implementing the statute’s underwriting exemption, the Agencies have determined to retain the general structure of the proposed underwriting exemption. For instance, two commenters suggested providing a safe harbor for ‘‘plain vanilla’’ or ‘‘basic’’ underwritings of stocks and bonds.308 The Agencies do not believe that a safe harbor is necessary to provide certainty that a banking entity may act as an underwriter in these particular types of offerings. This is because ‘‘plain vanilla’’ or ‘‘basic’’ underwriting activity should be able to meet the requirements of the final rule. For example, the final definition of ‘‘distribution’’ includes any offering of securities made pursuant to an effective registration statement under the Securities Act.309 Further, in response to one commenter’s request that the final rule prohibit a banking entity from acting as an underwriter in illiquid assets that are determined to not have
observable price inputs under accounting standards,310 the Agencies continue to believe that it would be inappropriate to incorporate accounting standards in the rule because accounting standards could change in the future without consideration of the potential impact on the final rule.311 Moreover, the Agencies do not believe it is necessary to differentiate between liquid and less liquid securities for purposes of determining whether a banking entity may underwrite a distribution of securities because, in either case, a banking entity must have a reasonable expectation of purchaser demand for the securities and must make reasonable efforts to sell or otherwise reduce its underwriting position within a reasonable period under the final rule.312 Another commenter suggested that the Agencies establish a strong presumption that all of a banking entity’s activities related to underwriting are permitted under the rule as long as the banking entity has adequate compliance and risk management procedures.313 While strong compliance and risk management procedures are important for banking entities’ permitted activities, the Agencies believe that an approach focused solely on the establishment of a compliance program would likely increase the potential for evasion of the general prohibition on proprietary trading. Similarly, the Agencies are not adopting an exemption that is unlimited, as requested by one commenter, because the Agencies believe controls are necessary to prevent potential evasion of the statute through, among other things, retaining an unsold allotment when there is sufficient customer interest for the securities and to limit the risks associated with these activities.314 Underwriters play an important role in facilitating issuers’ access to funding, and thus underwriters are important to the capital formation process and economic growth.315 Obtaining new financing can be expensive for an issuer because of the natural information advantage that less well-known issuers have over investors about the quality of their future investment opportunities. An underwriter can help reduce these costs by mitigating the information asymmetry between an issuer and its potential investors. The underwriter does this based in part on its familiarity with the issuer and other similar issuers as well as by collecting information about the issuer. This allows investors to look to the reputation and experience of the underwriter as well as its ability to provide information about the issuer and the underwriting. For these and other reasons, most U.S. issuers rely on the services of an underwriter when raising funds through public offerings. As recognized in the statute, the exemption is intended to permit banking entities to continue to perform the underwriting function, which contributes to capital formation and its positive economic effects.
c. Detailed Explanation of the
Underwriting Exemption

Acting as an Underwriter for a
Distribution of Securities a. Proposed Requirements That the Purchase or Sale be Effected Solely in Connection With a Distribution of Securities for Which the Banking Entity Acts as an Underwriter and That the Covered Financial Position be a Security
Section ll.4(a)(2)(iii) of the
proposed rule required that the purchase or sale be effected solely in connection with a distribution of securities for which a banking entity is acting as underwriter.316 As discussed below, the Agencies proposed to define the terms ‘‘distribution’’ and ‘‘underwriter’’ in the proposed rule. The proposed rule also required that the covered financial position being purchased or sold by the banking entity be a security.317
i. Proposed Definition of ‘‘Distribution’’
The proposed definition of ‘‘distribution’’ mirrored the definition of this term used in the SEC’s Regulation M under the Exchange Act.318 More specifically, the proposed rule defined ‘‘distribution’’ as ‘‘an offering of securities, whether or not subject to registration under the Securities Act, that is distinguished from ordinary trading transactions by the magnitude of the offering and the presence of special selling efforts and selling methods.’’319 The Agencies did not propose to define the terms ‘‘magnitude’’ and ‘‘special selling efforts and selling methods,’’ but stated that the Agencies would expect to rely on the same factors considered in Regulation M for assessing these elements.320 The Agencies noted that

addition, delivering a sales document, such as a prospectus, and conducting road shows are generally indicative of special selling efforts and selling methods. Another indicator of special selling efforts and selling methods is compensation that is greater than that for secondary trades but consistent with underwriting compensation for an offering.’’); CFTC Proposal, 77 FR 8352; Review of Antimanipulation Regulation of Securities Offering, Exchange Act Release No. 33924 (Apr. 19, 1994), 59 FR 21,681, 21,684–21,685 (Apr. 26, 1994). 321See Joint Proposal, 76 FR 68,867; CFTC Proposal, 77 FR 8352. 322See Joint Proposal, 76 FR 68,866–68,867; CFTC Proposal, 77 FR 8352; 17 CFR 242.101; proposed rule §ll.4(a)(4). 323See proposed rule §ll.4(a)(4). As noted in the proposal, the proposed rule’s definition differed from the definition in Regulation M because the proposed rule’s definition would also include a person who has an agreement with another underwriter to engage in a distribution of securities for or on behalf of an issuer or selling security holder. See Joint Proposal, 76 FR 68,867; CFTC Proposal, 77 FR 8352. 324See Joint Proposal, 76 FR 68,867; CFTC Proposal, 77 FR 8352. 325See id. 326See proposed rule §ll.4(a)(2)(ii). 327See Joint Proposal, 76 FR 68,866; CFTC Proposal, 77 FR 8352. 328See Joint Proposal, 76 FR 68,866 n.132; CFTC Proposal, 77 FR 8352 n.138. 329See, e.g., Goldman (Prop. Trading); SIFMA et al. (Prop. Trading) (Feb. 2012). 330See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); Wells Fargo (Prop. Trading); RBC. 331See Occupy. 332See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); Wells Fargo (Prop. Trading); RBC. 333See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); Wells Fargo (Prop. Trading). In addition, one commenter expressed general concern that the proposed rule would cause a reduction in underwriting services with respect to commercial paper, which would reduce liquidity in commercial paper markets and raise the costs of capital in already tight credit markets. See Chamber (Feb. 2012). 334See Goldman (Prop. Trading); Wells Fargo (Prop. Trading); RBC; LSTA (Feb. 2012). 335See Goldman (Prop. Trading). 336See SIFMA et al. (Prop. Trading) (Feb. 2012). 337See SIFMA et al. (Prop. Trading) (Feb. 2012). 338See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); Wells Fargo (Prop. Trading). 339See RBC. ‘‘magnitude’’ does not imply that a distribution must be large and, therefore, this factor would not preclude small offerings or private placements from qualifying for the proposed underwriting exemption.321
ii. Proposed Definition of ‘‘Underwriter’’
Like the proposed definition of ‘‘distribution,’’ the Agencies proposed to define ‘‘underwriter’’ in a manner similar to the definition of this term in the SEC’s Regulation M.322 The definition of ‘‘underwriter’’ in the proposed rule was: (i) Any person who has agreed with an issuer or selling security holder to: (a) Purchase securities for distribution; (b) engage in a distribution of securities for or on behalf of such issuer or selling security holder; or (c) manage a distribution of securities for or on behalf of such issuer or selling security holder; and (ii) a person who has an agreement with another person described in the preceding provisions to engage in a distribution of such securities for or on behalf of the issuer or selling security holder.323 In connection with this proposed requirement, the Agencies noted that the precise activities performed by an underwriter may vary depending on the liquidity of the securities being underwritten and the type of distribution being conducted. To determine whether a banking entity is acting as an underwriter as part of a distribution of securities, the Agencies proposed to take into consideration the extent to which a banking entity is engaged in the following activities:

Assisting an issuer in capitalraising;
Performing due diligence;
Advising the issuer on market
conditions and assisting in the preparation of a registration statement or other offering document;
Purchasing securities from an
issuer, a selling security holder, or an underwriter for resale to the public;
Participating in or organizing a
syndicate of investment banks;
Marketing securities; and
Transacting to provide a postissuance secondary market and to
facilitate price discovery.324 The proposal recognized that there may be circumstances in which an underwriter would hold securities that it could not sell in the distribution for investment purposes. The Agencies stated that if the unsold securities were acquired in connection with underwriting under the proposed exemption, then the underwriter would be able to dispose of such securities at a later time.325
iii. Proposed Requirement That the
Covered Financial Position Be a Security Pursuant to § ll.4(a)(2)(ii) of the proposed exemption, a banking entity would be permitted to purchase or sell a covered financial position that is a security only in connection with its underwriting activities.326 The proposal stated that this requirement was meant to reflect the common usage and understanding of the term ‘‘underwriting.’’ 327 It was noted, however, that a derivative or commodity future transaction may be otherwise permitted under another exemption (e.g., the exemptions for market makingrelated or risk-mitigating hedging activities).328 b. Comments on the Proposed Requirements That the Trade Be Effected Solely in Connection With a Distribution for Which the Banking Entity Is Acting as an Underwriter and That the Covered Financial Position Be a Security In response to the proposed requirement that a purchase or sale be ‘‘effected solely in connection with a distribution of securities’’ for which the ‘‘banking entity is acting as underwriter,’’ commenters generally focused on the proposed definitions of ‘‘distribution’’ and ‘‘underwriter’’ and the types of activities that should be permitted under the ‘‘in connection with’’ standard. Commenters did not directly address the requirement in § ll.4(a)(2)(ii) of the proposed rule, which provided that the covered financial position purchased or sold under the exemption must be a security. A number of commenters expressed general concern that the proposed underwriting exemption’s references to a ‘‘purchase or sale of a covered financial position’’ could be interpreted to require compliance with the proposed rule on a transaction-bytransaction basis. These commenters indicated that such an approach would be overly burdensome.329
i. Definition of ‘‘Distribution’’
Several commenters stated that the proposed definition of ‘‘distribution’’ is too narrow,330 while one commenter stated that the proposed definition is too broad.331 Commenters who viewed the proposed definition as too narrow stated that it may exclude important capitalraising and financing transactions that do not appear to involve ‘‘special selling efforts and selling methods’’ or ‘‘magnitude.’’ 332 In particular, these commenters stated that the proposed definition of ‘‘distribution’’ may preclude a banking entity from participating in commercial paper issuances,333 bridge loans,334 ‘‘at-themarket’’ offerings or ‘‘dribble out’’ programs conducted off issuer shelf registrations,335 offerings in response to reverse inquiries,336 offerings through an automated execution system,337 small private offerings,338 or selling security holders’ sales of securities of issuers with large market capitalizations that are executed as underwriting transactions in the normal course.339 Several commenters suggested that the proposed definition be modified to

340See Goldman (Prop. Trading); SIFMA et al. (Prop. Trading) (Feb. 2012); RBC. 341See Goldman (Prop. Trading) (stating that this would capture, among other things, commercial paper issuances, issuer ‘‘dribble out’’ programs, and small private offerings, which involve the purchase of securities directly from an issuer with a view toward resale, but may not always be clearly distinguished by ‘‘special selling efforts and selling methods’’ or by ‘‘magnitude’’); SIFMA et al. (Prop. Trading) (Feb. 2012). 342See SIFMA et al. (Prop. Trading) (Feb. 2012). This commenter indicated that expanding the definition of ‘‘distribution’’ to include both offerings of securities by an issuer and offerings by a selling security holder that are registered under the Securities Act or that involve an offering document prepared by the issuer would ‘‘include, for example, an offering of securities by an issuer or a selling security holder where securities are sold through an automated order execution system, offerings in response to reverse inquiries and commercial paper issuances.’’ Id. 343See RBC. 344See Goldman (Prop. Trading); RBC. In addition, one commenter requested the Agencies clarify that permitted underwriting activities include the acquisition and resale of securities issued in lieu of or to refinance bridge loan facilities, irrespective of whether such activities qualify as ‘‘distributions’’ under the proposal. See LSTA (Feb. 2012). 345See Goldman (Prop. Trading). 346See Occupy. 347See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); Wells Fargo (Prop. Trading). 348See AFR et al. (Feb. 2012); Public Citizen; Occupy (suggesting that the Agencies exceeded their statutory authority by incorporating the Regulation M definition of ‘‘underwriter,’’ rather than the Securities Act definition of ‘‘underwriter’’). 349See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); Wells Fargo (Prop. Trading). The term ‘‘distribution participant’’ is defined in Rule 100 of Regulation M as ‘‘an underwriter, prospective underwriter, broker, dealer, or other person who has agreed to participate or is participating in a distribution.’’ 17 CFR 242.100. 350See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); Wells Fargo (Prop. Trading). 351See Goldman (Prop. Trading). 352See SIFMA et al. (Prop. Trading) (Feb. 2012). This commenter also requested a technical amendment to proposed rule §ll.4(a)(4)(ii) to clarify that the person is ‘‘participating’’ in a distribution, not ‘‘engaging’’ in a distribution. See id. 353See AFR et al. (Feb. 2012); Public Citizen. 354See BoA; ICI Global; Vanguard; ICI (Feb. 2012); SSgA (Feb. 2012). As one commenter explained, an AP may ‘‘seed’’ an ETF for a short period of time at its inception by entering into several initial creation transactions with the ETF issuer and refraining from selling those shares to investors or redeeming them for a period of time to facilitate the ETF achieving its liquidity launch
goals. See BoA. 355See ICI Global; ICI (Feb. 2012); Vanguard. include some or all of these types of offerings.340 For example, two commenters requested that the definition explicitly include all offerings of securities by an issuer.341 One of these commenters further requested a broader definition that would include any offering by a selling security holder that is registered under the Securities Act or that involves an offering document prepared by the issuer.342 Another commenter suggested that the rule explicitly authorize certain forms of offerings, such as offerings under Rule 144A, Regulation S, Rule 101(b)(10) of Regulation M, or the socalled ‘‘section 4(11⁄2)’’ of the Securities Act, as well as transactions on behalf of selling security holders.343 Two commenters proposed approaches that would include the resale of notes or other debt securities received by a banking entity from a borrower to replace or refinance a bridge loan.344 One of these commenters stated that permitting a banking entity to receive and resell notes or other debt securities from a borrower to replace or refinance a bridge loan would preserve the ability of a banking entity to extend credit and offer customers a range of financing options. This commenter further represented that such an approach would be consistent with the exclusion of loans from the proposed definition of ‘‘covered financial position’’ and the commenter’s recommended exclusion from the definition of ‘‘trading account’’ for collecting debts previously contracted.345 One commenter, however, stated that the proposed definition of ‘‘distribution’’ is too broad. This commenter suggested that the underwriting exemption should only be available for registered offerings, and the rule should preclude a banking entity from participating in a private placement. According to the commenter, permitting a banking entity to participate in a private placement may facilitate evasion of the prohibition on proprietary trading.346
ii. Definition of ‘‘Underwriter’’
Several commenters stated that the proposed definition of ‘‘underwriter’’ is too narrow.347 Other commenters, however, stated that the proposed definition is too broad, particularly due to the proposed inclusion of selling group members.348 Commenters requesting a broader definition generally stated that the Agencies should instead use the Regulation M definition of ‘‘distribution participant’’ or otherwise revise the definition of ‘‘underwriter’’ to incorporate the concept of a ‘‘distribution participant,’’ as defined under Regulation M.349 According to these commenters, using the term ‘‘distribution participant’’ would better reflect current market practice and would include dealers that participate in an offering but that do not deal directly with the issuer or selling security holder and do not have a written agreement with the underwriter.350 One commenter further represented that the proposed provision for selling group members may be less inclusive than the Agencies intended because individual selling dealers or dealer groups may or may not have written agreements with an underwriter in privity of contract with the issuer.351 Another commenter requested that, if the ‘‘distribution participant’’ concept is not incorporated into the rule, the proposed definition of ‘‘underwriter’’ be modified to include a person who has an agreement with an affiliate of an issuer or selling security holder (e.g., an agreement with a parent company to distribute the issuer’s securities).352 Other commenters opposed the inclusion of selling group members in the proposed definition of ‘‘underwriter.’’ These commenters stated that because selling group members do not provide a price guarantee to an issuer, they do not provide services to a customer and their activities should not qualify for the underwriting exemption.353 A number of commenters stated that it is unclear whether the proposed underwriting exemption would permit a banking entity to act as an authorized participant (‘‘AP’’) to an ETF issuer, particularly with respect to the creation and redemption of ETF shares or ‘‘seeding’’ an ETF for a short period of time when it is initially launched.354 For example, a few commenters noted that APs typically do not perform some or all of the activities that the Agencies proposed to consider to help determine whether a banking entity is acting as an underwriter in connection with a distribution of securities, including due diligence, advising an issuer on market conditions and assisting in preparation of a registration statement or offering documents, and participating in or organizing a syndicate of investment banks.355 However, one commenter appeared to oppose applying the underwriting exemption to certain AP activities. According to this commenter, APs are generally reluctant to concede that they are statutory underwriters because they do not perform all the activities associated with the underwriting of an operating company’s securities. Further, this
commenter expressed concern that, if an AP had to rely on the proposed underwriting exemption, the AP could be subject to heightened risk of incurring underwriting liability on the issuance of ETF shares traded by the AP. As a result of these considerations,

356See SSgA (Feb. 2012).
357See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); BoA; Wells Fargo (Prop. Trading); Comm. on Capital Markets Regulation. 358See Goldman (Prop. Trading). 359See Goldman (Prop. Trading); Wells Fargo (Prop. Trading); SIFMA et al. (Prop. Trading) (Feb. 2012). 360See Goldman (Prop. Trading). 361See SIFMA et al. (Prop. Trading) (Feb. 2012). 362See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); Wells Fargo (Prop. Trading); RBC. 363See SIFMA et al. (Prop. Trading) (Feb. 2012) (‘‘The reason for creating the short positions (covered and naked) is to facilitate an orderly aftermarket and to reduce price volatility of newly offered securities. This provides significant value to issuers and selling security holders, as well as to investors, by giving the syndicate buying power that helps protect against immediate volatility in the aftermarket.’’); RBC; Goldman (Prop. Trading). 364See SIFMA et al. (Prop. Trading) (Feb. 2012) (‘‘Underwriters may also engage in stabilization activities under Regulation M by creating a stabilizing bid to prevent or slow a decline in the market price of a security. These activities should be encouraged rather than restricted by the Volcker Rule because they reduce price volatility and facilitate the orderly pricing and aftermarket trading of underwritten securities, thereby contributing to capital formation.’’). 365See RBC. 366See Goldman (Prop. Trading). 367See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading) (stating that the call spread arrangement ‘‘may make a wider range of financing options feasible for the issuer of the convertible debt’’ and ‘‘can help it to raise more capital at more attractive prices’’). 368See Wells Fargo (Prop. Trading). The commenter further stated that the need to purchase the issuer’s other debt securities from investors may arise if an investor has limited risk tolerance to the issuer’s credit or has portfolio restrictions. According to the commenter, the underwriter would typically sell the debt securities it purchased from existing investors to new investors. See id. 369See Wells Fargo (Prop. Trading). 370See Goldman (Prop. Trading). 371See ASF (Feb. 2012) (stating that, for example, a banking entity may respond to customer or general market demand for highly-rated mortgage paper by accumulating residential mortgage-backed securities over time and holding such securities in inventory until the transaction can be organized and assembled). 372See ICI (Feb. 2012) (stating that the sale of assets to an intermediate asset-backed commercial paper or tender option bond program should be permitted under the underwriting exemption if the sale is part of the creation of a structured security). See also AFR et al. (Feb. 2012) (stating that the treatment of a sale to an intermediate entity should depend on whether the banking entity or an external client is the driver of the demand and, if the banking entity is the driver of the demand, then the
near term demand requirement should not be met). Two commenters stated that the underwriting exemption should not permit a banking entity to sell a security to an intermediate entity in the course of creating a structured product. See Occupy; Alfred Brock. These commenters were generally responding to a question on this issue in the proposal. See Joint Proposal, 76 FR 68,868– 68,869 (question 78); CFTC Proposal, 77 FR 8354 (question 78). 373Final rule §ll.4(a)(2)(i). The terms ‘‘distribution’’ and ‘‘underwriter’’ are defined in final rule §ll.4(a)(3) and §ll.4(a)(4), respectively. 374Proposed rule §ll.4(a)(2)(iii) required that ‘‘[t]he purchase or sale is effected solely in connection with a distribution of securities for which the covered banking entity is acting as underwriter.’’ 375See, e.g., Goldman (Prop. Trading); SIFMA et al. (Prop. Trading) (Feb. 2012). the commenter believed that a banking entity may be less willing to act as an AP for an ETF issuer if it were required to rely on the underwriting exemption.356
iii. ‘‘Solely in Connection With’’
Standard
To qualify for the underwriting exemption, the proposed rule required a purchase or sale of a covered financial position to be effected ‘‘solely in connection with’’ a distribution of securities for which the banking entity is acting as underwriter. Several commenters expressed concern that the word ‘‘solely’’ in this provision may result in an overly narrow interpretation of permissible activities. In particular, these commenters indicated that the ‘‘solely in connection with’’ standard creates uncertainty about certain activities that are currently conducted in the course of an underwriting, such as customary underwriting syndicate activities.357 One commenter represented that such activities are traditionally undertaken to: Support the success of a distribution; mitigate risk to issuers, investors, and underwriters; and facilitate an orderly aftermarket.358 A few commenters further stated that requiring a trade to be ‘‘solely’’ in connection with a distribution by an underwriter would be inconsistent with the statute,359 may reduce future innovation in the capital-raising process,360 and could create market disruptions.361 A number of commenters stated that it is unclear whether certain activities would qualify for the proposed underwriting exemption and requested that the Agencies adopt an exemption that is broad enough to permit such activities.362 Commenters stated that there are a number of activities that should be permitted under the underwriting exemption, including: (i) Creating a naked or covered syndicate short position in connection with an offering; 363 (ii) creating a stabilizing bid; 364 (iii) acquiring positions via overallotments 365 or trading in the market to close out short positions in connection with an overallotment option or in connection with other stabilization activities; 366 (iv) using call spread options in a convertible debt offering to mitigate dilution of existing shareholders; 367 (v) repurchasing existing debt securities of an issuer in the course of underwriting a new series of debt securities in order to stimulate demand for the new issuance; 368 (vi) purchasing debt securities of comparable issuers as a price discovery mechanism in connection with underwriting a new debt security; 369 (vii) hedging the underwriter’s exposure to a derivative strategy engaged in with an issuer; 370 (viii) organizing and assembling a resecuritized product, including, for example, sourcing bond collateral over a period of time in anticipation of issuing new securities; 371 and (ix) selling a security to an intermediate entity as part of the creation of certain structured products.372
c. Final Requirement That the Banking
Entity Act as an Underwriter for a Distribution of Securities and the Trading Desk’s Underwriting Position Be Related to Such Distribution The final rule requires that the banking entity act as an underwriter for a distribution of securities and the trading desk’s underwriting position be related to such distribution.373 This requirement is substantially similar to the proposed rule,374 but with five key refinements. First, to address commenters’ confusion about whether the underwriting exemption applies on a transaction-by-transaction basis, the phrase ‘‘purchase or sale’’ has been modified to instead refer to the trading desk’s ‘‘underwriting position.’’ Second, to balance this more aggregated position-based approach, the final rule specifies that the trading desk is the organizational level of a banking entity (or across one or more affiliated banking entities) at which the requirements of the underwriting exemption will be assessed. Third, the Agencies have made important modifications to the definition of ‘‘distribution’’ to better capture the various types of private and registered offerings a banking entity may be asked to underwrite by an issuer or selling security holder. Fourth, the definition of ‘‘underwriter’’ has been refined to clarify that both members of the underwriting syndicate and selling group members may qualify as underwriters for purposes of this exemption. Finally, the word ‘‘solely’’ has been removed to clarify that a broader scope of activities conducted in connection with underwriting (e.g., stabilization activities) are permitted under this exemption. These issues are discussed in turn below.
i. Definition of ‘‘Underwriting Position’’
In response to commenters’ concerns about transaction-by-transaction analyses,375 the Agencies are modifying

376See infra Part IV.A.3.c. (discussing the final market-making exemption). 377See supra note 302 and accompanying text. 378Final rule §ll.4(a)(3). 379Proposed rule §ll.4(a)(3) defined ‘‘distribution’’ as ‘‘an offering of securities, whether or not subject to registration under the Securities Act, that is distinguished from ordinary trading transactions by the magnitude of the offering and the presence of special selling efforts and selling methods.’’ 380The policy goals of this rule differ from those of the SEC’s Regulation M, which is an antimanipulation rule. The focus on magnitude is appropriate for that regulation because it helps identify offerings that can give rise to an incentive to condition the market for the offered security. To the contrary, this rule is intended to allow banking entities to continue to provide client-oriented financial services, including underwriting services. The SEC emphasizes that this rule does not have any impact on Regulation M. the exemption to clarify the level at which compliance with certain provisions will be assessed. The proposal was not intended to impose a transaction-by-transaction approach, and the final rule’s requirements generally focus on the long or short positions in one or more securities held by a banking entity or its affiliate, and managed by a particular trading desk, in connection with a particular distribution of securities for which such banking entity or its affiliate is acting as an underwriter. Like §ll.4(a)(2)(ii) of the proposed rule, the definition of ‘‘underwriting position’’ is limited to positions in securities because the common usage and understanding of the term ‘‘underwriting’’ is limited to activities in securities. A trading desk’s underwriting position constitutes the securities positions that are acquired in connection with a single distribution for which the relevant banking entity is acting as an underwriter. A trading desk may not aggregate securities positions acquired in connection with two or more distributions to determine its ‘‘underwriting position.’’ A trading desk may, however, have more than one ‘‘underwriting position’’ at a particular point in time if the banking entity is acting as an underwriter for more than one distribution. As a result, the underwriting exemption’s requirements pertaining to a trading desk’s underwriting position will apply on a distribution-by-distribution basis. A trading desk’s underwriting position can include positions in securities held at different affiliated legal entities, provided the banking entity is able to provide supervisors or examiners of any Agency that has regulatory authority over the banking entity pursuant to section 13(b)(2)(B) of the BHC Act with records, promptly upon request, that identify any related positions held at an affiliated entity that are being included in the trading desk’s underwriting position for purposes of the underwriting exemption. Banking entities should be prepared to provide all
records that identify all of the positions included in a trading desk’s underwriting position and where such positions are held. The Agencies believe that a distribution-by-distribution approach is appropriate due to the relatively distinct nature of underwriting activities for a single distribution on behalf of an issuer or selling security holder. The Agencies do not believe that a narrower transaction-by-transaction analysis is necessary to determine whether a banking entity is engaged in permitted underwriting activities. The Agencies also decline to take a broader approach, which would allow a banking entity to aggregate positions from multiple distributions for which it is acting as an underwriter, because it would be more difficult for the banking entity’s internal compliance personnel and Agency supervisors and examiners to review the trading desk’s positions to assess the desk’s compliance with the underwriting exemption. A more aggregated approach would increase the number of positions in different types of securities that could be included in the underwriting position, which would make it more difficult to determine that an individual position is related to a particular distribution of securities for which the banking entity is acting as an underwriter and, in turn, increase the potential for evasion of the general prohibition on proprietary trading.
ii. Definition of ‘‘Trading Desk’’
The proposed underwriting exemption would have applied certain requirements across an entire banking entity. To promote consistency with the market-making exemption and address potential evasion concerns, the final rule applies the requirements of the underwriting exemption at the trading desk level of organization.376 This approach will result in the requirements of the underwriting exemption applying to the aggregate trading activities of a relatively limited group of employees on a single desk. Applying requirements at the trading desk level should facilitate banking entity and Agency monitoring and review of compliance with the exemption by limiting the location where underwriting activity may occur and allowing better identification of the aggregate trading volume that must be reviewed to determine whether the desk’s activities are being conducted in a manner that is consistent with the underwriting exemption, while also allowing adequate consideration of the particular facts and circumstances of the desk’s trading activities. The trading desk should be managed and operated as an individual unit and should reflect the level at which the profit and loss of employees engaged in underwriting activities is attributed. The term ‘‘trading desk’’ in the underwriting context is intended to encompass what is commonly thought of as an underwriting desk. A trading desk engaged in underwriting activities would not necessarily be an active market participant that engages in frequent trading activities. A trading desk may manage an underwriting position that includes positions held by different affiliated legal entities.377 Similarly, a trading desk may include employees working on behalf of multiple affiliated legal entities or booking trades in multiple affiliated entities. The geographic location of individual traders is not dispositive for purposes of determining whether the employees are engaged in activities for a single trading desk.
iii. Definition of ‘‘Distribution’’
The term ‘‘distribution’’ is defined in the final rule as: (i) An offering of securities, whether or not subject to registration under the Securities Act, that is distinguished from ordinary trading transactions by the presence of special selling efforts and selling methods; or (ii) an offering of securities made pursuant to an effective registration statement under the Securities Act.378 In response to comments, the proposed definition has been revised to eliminate the need to consider the ‘‘magnitude’’ of an offering and instead supplements the definition with an alternative prong for registered offerings under the Securities Act.379 The proposed definition’s reference to magnitude caused some commenter concern with respect to whether it could be interpreted to preclude a banking entity from intermediating a small private placement. After considering comments, the Agencies have determined that the requirement to have special selling efforts and selling methods is sufficient to distinguish between permissible securities offerings and prohibited proprietary trading, and the additional magnitude factor is not needed to further this objective.380 As proposed, the Agencies will rely on the same factors considered under Regulation M to analyze the presence of special selling efforts and selling

381See Joint Proposal, 76 FR 68,867; CFTC Proposal, 77 FR 8352. 382See Joint Proposal, 76 FR 68,867; CFTC Proposal, 77 FR 8352; Review of Antimanipulation Regulation of Securities Offering, Exchange Act Release No. 33924 (Apr. 19, 1994), 59 FR 21,681, 21,684–21,685 (Apr. 26, 1994). 383The final rule does not provide safe harbors for particular distribution techniques. A safe harbor-based approach would provide certainty for specific types of offerings, but may not account for evolving market practices and distribution techniques that could technically satisfy a safe harbor but that might implicate the concerns that led Congress to enact section 13 of the BHC Act. See RBC. 384This clarification is intended to address commenters’ concern regarding potential limitations on banking entities’ ability to facilitate commercial paper offerings under the proposed underwriting exemption. See supra Part IV.A.2.c.1.b.i. 385See, e.g., Form S–1 (17 CFR 239.11); Form S– 3 (17 CFR 239.13); Form S–8 (17 CFR 239.16b); Form F–1 (17 CFR 239.31); Form F–3 (17 CFR 239.33). 386Although the Agencies are providing an additional prong to the definition of ‘‘distribution’’ for registered offerings, the final rule does not limit the availability of the underwriting exemption to registered offerings, as suggested by one commenter. The statute does not include such an express limitation, and the Agencies decline to construe the statute to require such an approach. In response to the commenter stating that permitting a banking entity to participate in a private placement may facilitate evasion of the prohibition on proprietary trading, the Agencies believe this concern is addressed by the provision in the final rule requiring that a trading desk have a reasonable expectation of demand from other market participants for the amount and type of securities to be acquired from an issuer or selling security holder for distribution and make reasonable efforts to sell its underwriting position within a reasonable period. As discussed below, the Agencies believe this requirement in the final rule appropriately addresses evasion concerns that a banking entity may retain an unsold allotment for purely speculative purposes. Further, the Agencies believe that preventing a banking entity from facilitating a private offering could unnecessarily hinder capitalraising without providing commensurate benefits because issuers use private offerings to raise capital in a variety of situations and the underwriting exemption’s requirements limit the potential for evasion for both registered and private offerings, as noted above. 387See Securities Offering Reform, Securities Act Release No. 8591 (July 19, 2005), 70 FR 44,722 (Aug. 3, 2005); 17 CFR 230.405 (defining ‘‘automatic shelf registration statement’’ as a registration statement filed on Form S–3 (17 CFR 239.13) or Form F–3 (17 CFR 239.33) by a wellknown seasoned issuer pursuant to General Instruction I.D. or I.C. of such forms, respectively);
17 CFR 230.415. 388A bought deal is a distribution technique whereby an underwriter makes a bid for securities without engaging in a preselling effort, such as book building or distribution of a preliminary prospectus. See, e.g., Delayed or Continuous Offering and Sale of Securities, Securities Act Release No. 6470 (June 9, 1983), n.5. 389See, e.g., 17 CFR 230.415(a)(4) (defining ‘‘at the market offering’’ as ‘‘an offering of equity securities into an existing trading market for outstanding shares of the same class at other than a fixed price’’). At the market offerings may also be referred to as ‘‘dribble out’’ programs. 390Under the ‘‘reverse inquiry’’ process, an investor may be allowed to purchase securities from the issuer through an underwriter that is not designated in the prospectus as the issuer’s agent by having such underwriter approach the issuer with an interest from the investor. See Joseph McLaughlin and Charles J. Johnson, Jr., ‘‘Corporate Finance and the Securities Laws’’ (4th ed. 2006, supplemented 2012). 391See SIFMA et al. (Prop. Trading) (Feb. 2012). 392See final rule §ll.4(a)(4). methods.381 Indicators of special selling efforts and selling methods include delivering a sales document (e.g., a prospectus), conducting road shows, and receiving compensation that is greater than that for secondary trades but consistent with underwriting compensation.382 For purposes of the final rule, each of these factors need not be present under all circumstances. Offerings that qualify as distributions under this prong of the definition include, among others, private placements in which resales may be made in reliance on the SEC’s Rule 144A or other available exemptions 383 and, to the extent the commercial paper being offered is a security, commercial paper offerings that involve the underwriter receiving special compensation.384 The Agencies are also adopting a second prong to this definition, which will independently capture all offerings of securities that are made pursuant to an effective registration statement under the Securities Act.385 The registration prong of the definition is intended to provide another avenue by which an offering of securities may be conducted under the exemption, absent other special selling efforts and selling methods or a determination of whether such efforts and methods are being conducted. The Agencies believe this prong reduces potential administrative burdens by providing a bright-line test for what constitutes a distribution for purposes of the final rule. In addition, this prong is consistent with the purpose and goals of the statute because it reflects a common type of securities offering and does not raise evasion concerns as it is unlikely that an entity would go through the registration process solely to facilitate or engage in speculative proprietary trading.386 This prong would include, among other things, the following types of registered securities offerings: Offerings made pursuant to a shelf
registration statement (whether on a continuous or delayed basis),387 bought deals,388 at the market offerings,389 debt offerings, assetbacked security offerings, initial public offerings, and other registered offerings. An offering can be a distribution for purposes of either §ll.4(a)(3)(i) or § ll.4(a)(3)(ii) of the final rule regardless of whether the offering is issuer driven, selling security holder driven, or arises as a result of a reverse inquiry.390 Provided the definition of distribution is met, an offering can be a distribution for purposes of this rule regardless of how it is conducted, whether by direct communication, exchange transactions, or automated execution system.391 As discussed above, some commenters expressed concern that the proposed definition of ‘‘distribution’’ would prevent a banking entity from acquiring and reselling securities issued in lieu of or to refinance bridge loan facilities in reliance on the underwriting exemption. Bridge financing arrangements can be structured in many different ways, depending on the context and the specific objectives of the parties involved. As a result, the treatment of securities acquired in lieu of or to refinance a bridge loan and the subsequent sale of such securities under the final rule depends on the facts and circumstances. A banking entity may meet the terms of the underwriting exemption for its bridge loan activity, or it may be able to rely on the marketmaking exemption. If the banking entity’s bridge loan activity does not qualify for an exemption under the rule, then it would not be permitted to engage in such activity.
iv. Definition of ‘‘Underwriter’’
In response to comments, the Agencies are adopting certain modifications to the proposed definition of ‘‘underwriter’’ to better capture selling group members and to more closely resemble the definition of ‘‘distribution participant’’ in Regulation M. In particular, the Agencies are defining ‘‘underwriter’’ as: (i) A person who has agreed with an issuer or selling security holder to: (A) Purchase securities from the issuer or selling security holder for distribution; (B) engage in a distribution of securities for or on behalf of the issuer or selling security holder; or (C) manage a distribution of securities for or on behalf of the issuer or selling security holder; or (ii) a person who has agreed to participate or is participating in a distribution of such securities for or on behalf of the issuer or selling security holder.392 A number of commenters requested that the Agencies broaden the underwriting exemption to permit activities in connection with a distribution of securities by any distribution participant. A few of these commenters interpreted the proposed definition of ‘‘underwriter’’ as requiring a selling group member to have a written agreement with the underwriter

393The basic documents in firm commitment underwritten securities offerings generally are: (i) The agreement among underwriters, which establishes the relationship among the managing underwriter, any co-managers, and the other members of the underwriting syndicate; (ii) the underwriting (or ‘‘purchase’’) agreement, in which the underwriters commit to purchase the securities from the issuer or selling security holder; and (iii) the selected dealers agreement, in which selling group members agree to certain provisions relating to the distribution. See Joseph McLaughlin and Charles J. Johnson, Jr., ‘‘Corporate Finance and the Securities Laws’’ (4th ed. 2006, supplemented 2012), Ch. 2. The Agencies understand that two firms may enter into a master agreement that governs all offerings in which both firms participate as members of the underwriting syndicate or as a member of the syndicate and a selling group member. See, e.g., SIFMA Master Selected Dealers Agreement (June 10, 2011), available at www.sifma.org. 394See AFR et al. (Feb. 2012); Public Citizen. 395See Joint Proposal, 76 FR 68,867; CFTC Proposal, 77 FR 8352. Post-issuance secondary market activity is expected to be conducted in accordance with the market-making exemption. 396See infra Part IV.A.3. 397See final rule §ll.3(e)(9) (defining the term ‘‘issuer’’ for purposes of the proprietary trading provisions in subpart B of the final rule). Under
section 2(a)(4) of the Securities Act, ‘‘issuer’’ is
defined as ‘‘every person who issues or proposes to issue any security; except that with respect to certificates of deposit, voting-trust certificates, or collateral-trust certificates, or with respect to certificates of interest or shares in an unincorporated investment trust not having a board of directors (or persons performing similar functions) or of the fixed, restricted management, or unit type, the term ‘issuer’ means the person or persons performing the acts and assuming the duties of depositor or manager pursuant to the provisions of the trust or other agreement or instrument under which such securities are issued; except that in the case of an unincorporated association which provides by its articles for limited liability of any or all of its members, or in the case of a trust, committee, or other legal entity, the trustees or members thereof shall not be individually liable as issuers of any security issued by the association, trust, committee, or other legal entity; except that with respect to equipment-trust certificates or like securities, the term ‘issuer’ means the person by whom the equipment or property is or is to be used; and except that with respect to fractional undivided interests in oil, gas, or other mineral rights, the term ‘issuer’ means the owner of any such right or of any interest in such right (whether whole or fractional) who creates fractional interests therein for the purpose of public offering.’’ 15 U.S.C. 77b(a)(4). 398Final rule §ll.4(a)(5). 399See 17 CFR 242.100(b). 400See supra Part IV.A.2.c.1.b.iii. 401See supra notes 357, 358, 363–372 and accompanying text. to participate in the distribution.393 These commenters noted that such a written agreement may not exist under all circumstances. The Agencies did not intend to require that members of the underwriting syndicate or the lead underwriter have a written agreement with all selling group members for each offering or that they be in privity of contract with the issuer or selling security holder. To provide clarity on this issue, the Agencies have modified the language of subparagraph (ii) of the definition to include firms that, while not members of the underwriting syndicate, have agreed to participate or are participating in a distribution of securities for or on behalf of the issuer or selling security holder. The final rule does not adopt a narrower definition of ‘‘underwriter,’’ as suggested by two commenters.394 Although selling group members do not have a direct relationship with the issuer or selling security holder, they do help facilitate the successful distribution of securities to a wider variety of purchasers, such as regional or retail purchasers that members of the underwriting syndicate may not be able to access as easily. Thus, the Agencies believe it is consistent with the purpose of the statutory underwriting exemption and beneficial to recognize and allow the current market practice of an underwriting syndicate and selling group members
collectively facilitating a distribution of securities. The Agencies note that because banking entities that are selling group members will be underwriters under the final rule, they will be subject to all the requirements of the underwriting exemption. As provided in the preamble to the proposed rule, engaging in the following activities may indicate that a banking entity is acting as an underwriter under § ll.4(a)(4) as part of a distribution of securities:

Assisting an issuer in capitalraising;
Performing due diligence;
Advising the issuer on market
conditions and assisting in the preparation of a registration statement or other offering document;
Purchasing securities from an
issuer, a selling security holder, or an underwriter for resale to the public;
Participating in or organizing a
syndicate of investment banks;
Marketing securities; and
Transacting to provide a postissuance secondary market and to
facilitate price discovery.395 The Agencies continue to take the view that the precise activities performed by an underwriter will vary depending on the liquidity of the securities being underwritten and the type of distribution being conducted. A banking entity is not required to engage in each of the above-noted activities to be considered an underwriter for purposes of this rule. In addition, the Agencies note that, to the extent a banking entity does not meet the definition of ‘‘underwriter’’ in the final rule, it may be able to rely on the market-making exemption in the final rule for its trading activity. In response to comments noting that APs for ETFs do not engage in certain of these activities and inquiring whether an AP would be able to qualify for the underwriting exemption for certain of its activities, the Agencies believe that many AP activities, such as conducting general creations and redemptions of ETF shares, are better suited for analysis under the market-making exemption because they are driven by the demands of other market participants rather than the issuer, the ETF.396 Whether an AP may rely on the underwriting exemption for its activities in an ETF will depend on the facts and circumstances, including, among other things, whether the AP meets the definition of ‘‘underwriter’’ and the offering of ETF shares qualifies as a ‘‘distribution.’’ To provide further clarity about the scope of the definition of ‘‘underwriter,’’ the Agencies are defining the terms ‘‘selling security holder’’ and ‘‘issuer’’ in the final rule. The Agencies are using the definition of ‘‘issuer’’ from the Securities Act because this definition is commonly used in the context of securities offerings and is well understood by market participants.397 A ‘‘selling security holder’’ is defined as ‘‘any person, other than an issuer, on whose behalf a distribution is made.’’ 398 This definition is consistent with the definition of ‘‘selling security holder’’ found in the SEC’s Regulation M.399
v. Activities Conducted ‘‘in Connection
With’’ a Distribution
As discussed above, several commenters expressed concern that the proposed underwriting exemption would not allow a banking entity to engage in certain auxiliary activities that may be conducted in connection with acting as an underwriter for a distribution of securities in the normal course. These commenters’ concerns generally arose from the use of the word ‘‘solely’’ in § ll.4(a)(2)(iii) of the proposed rule, which commenters noted was not included in the statute’s underwriting exemption.400 In addition, a number of commenters discussed particular activities they believed should be permitted under the underwriting exemption and indicated the term ‘‘solely’’ created uncertainty about whether such activities would be permitted.401 To reduce uncertainty in response to comments, the final rule requires a trading desk’s underwriting position to be ‘‘held . . . and managed . . . in connection with’’ a single distribution

402See SIFMA et al. (Prop. Trading) (Feb. 2012). See Anti-Manipulation Rules Concerning Securities Offerings, Exchange Act Release No. 38067 (Dec. 20, 1996), 62 FR 520, 535 (Jan. 3, 1997) (‘‘Although stabilization is price-influencing activity intended to induce others to purchase the offered security, when appropriately regulated it is an effective mechanism for fostering an orderly distribution of securities and promotes the interests of shareholders, underwriters, and issuers.’’). 403See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; Goldman (Prop. Trading). See Proposed Amendments to Regulation M: Anti-Manipulation Rules Concerning Securities Offerings, Exchange Act Release No. 50831 (Dec. 9, 2004), 69 FR 75,774, 75,780 (Dec. 17, 2004) (‘‘In the typical offering, the syndicate agreement allows the managing underwriter to ‘oversell’ the offering, i.e., establish a short position beyond the number of shares to which the underwriting commitment relates. The underwriting agreement with the issuer often provides for an ‘overallotment option’ whereby the syndicate can purchase additional shares from the issuer or selling shareholders in order to cover its short position. To the extent that the syndicate short position is in excess of the overallotment option, the syndicate is said to have taken an ‘uncovered’ short position. The syndicate short position, up to the amount of the overallotment option, may be covered by exercising the option or by purchasing shares in the market once secondary trading begins.’’). 404See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; BoA; BDA (Feb. 2012). 405See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; Goldman (Prop. Trading). 406See final rule §ll.4(a)(2)(ii); infra Part IV.A.2.c.2.c. (discussing the requirement to make reasonable efforts to sell or otherwise reduce the underwriting position). 407See final rule §ll.4(a)(2)(iii)(B); infra Part IV.A.2.c.3.c. (discussing the required limits for trading desks engaged in underwriting activity). 408See Wells Fargo (Prop. Trading). The Agencies do not believe this activity is consistent with underwriting activity because it could result in an underwriting desk holding a variety of positions over time that are not directly related to a distribution of securities the desk is conducting on behalf of an issuer or selling security holder. Further, the Agencies believe this activity may be more appropriately analyzed under the marketmaking exemption because market makers generally purchase or sell a financial instrument at the request of customers and otherwise routinely stand ready to purchase and sell a variety of related financial instruments. 409See id. The Agencies view this activity as inconsistent with underwriting because underwriters typically engage in other activities, such as book-building and other marketing efforts, to determine the appropriate price for a security and these activities do not involve taking positions that are unrelated to the securities
subject to distribution. See infra IV.A.2.c.2. 410Although one commenter suggested that an underwriter’s hedging activity be permitted under the underwriting exemption, we do not believe the requirements in the proposed hedging exemption would be unworkable or overly burdensome in the context of an underwriter’s hedging activity. See Goldman (Prop. Trading). As noted above, underwriting activity is of a relatively distinct nature, which is substantially different from market-making activity, which is more dynamic and involves more frequent trading activity giving rise to a variety of positions that may naturally hedge the risks of certain other positions. The Agencies believe it is appropriate to require that a trading desk comply with the requirements of the hedging exemption when it is hedging the risks of its underwriting position, while allowing a trading desk’s market making-related hedging under the market-making exemption. 411See ICI (Feb. 2012); AFR et al. (Feb. 2012); Occupy; Alfred Brock. 412A banking entity may accumulate loans in anticipation of securitization because loans are not financial instruments under the final rule. See supra Part IV.A.1.c. for which the relevant banking entity is acting as an underwriter, rather than requiring that a purchase or sale be ‘‘effected solely in connection with’’ such a distribution. Importantly, for purposes of establishing an underwriting position in reliance on the underwriting exemption, a trading desk may only engage in activities that are related to a particular distribution of securities for which the banking entity is acting as an underwriter. Activities that may be permitted under the underwriting exemption include stabilization activities,402 syndicate shorting and aftermarket short covering,403 holding an unsold allotment when market conditions may make it impracticable to sell the entire allotment at a reasonable price at the time of the distribution and selling such position when it is reasonable to do so,404 and helping the issuer mitigate its risk exposure arising from the distribution of its securities (e.g., entering into a call-spread option with an issuer as part of a convertible debt offering to mitigate dilution to existing shareholders).405 Such activities should be intended to effectuate the distribution process and provide benefits to issuers, selling security holders, or purchasers in the distribution. Existing laws, regulations, and self-regulatory organization rules limit or place certain requirements around many of these activities. For example, an underwriter’s subsequent sale of an unsold allotment must comply with applicable provisions of the federal securities laws and the rules thereunder. Moreover, any position resulting from these activities must be included in the trading desk’s underwriting position, which is subject to a number of restrictions in the final rule. Specifically, as discussed in more detail below, the trading desk must make reasonable efforts to
sell or otherwise reduce its underwriting position within a reasonable period,406 and each trading desk must have robust limits on, among other things, the amount, types, and risks of its underwriting position and the period of time a security may be held.407 Thus, in general, the underwriting exemption would not permit a trading desk, for example, to acquire a position as part of its stabilization activities and hold that position for an extended period. This approach does not mean that any activity that is arguably connected to a distribution of securities is permitted under the underwriting exemption. Certain activities noted by commenters are not core to the underwriting function and, thus, are not permitted under the final underwriting exemption. However, a banking entity may be able to rely on another exemption for such activities (e.g., the market-making or hedging exemptions), if applicable. For example, a trading desk would not be able to use the underwriting exemption to purchase a financial instrument from a customer to facilitate the customer’s ability to buy securities in the distribution.408 Further, purchasing another financial instrument to help determine how to price the securities that are subject to a distribution would not be permitted under the underwriting exemption.409 These two activities may be permitted under the market-making exemption, depending on the facts and circumstances. In response to one commenter’s suggestion that hedging the underwriter’s risk exposure be permissible under this exemption, the Agencies emphasize that hedging the underwriter’s risk exposure is not permitted under the underwriting exemption.410 A banking entity must comply with the hedging exemption for such activity. In response to comments about the sale of a security to an intermediate entity in connection with a structured finance product,411 the Agencies have not modified the underwriting exemption. Underwriting is distinct from product development. Thus, parties must adjust activities associated with developing structured finance products or meet the terms of other available exemptions. Similarly, the accumulation of securities or other assets in anticipation of a securitization or resecuritization is not an activity conducted ‘‘in connection with’’ underwriting for purposes of the exemption.412 This activity is typically engaged in by an issuer or sponsor of a securitized product in that capacity, rather than in the capacity of an underwriter. The underwriting exemption only permits a banking entity’s activities when it is acting as an underwriter.
2. Near Term Customer Demand
Requirement a. Proposed Near Term Customer Demand Requirement Like the statute, §ll.4(a)(2)(v) of the proposed rule required that the underwriting activities of the banking entity with respect to the covered

413See proposed rule §ll.4(a)(2)(v); Joint Proposal, 76 FR 68,867; CFTC Proposal, 77 FR 8353. 414See supra Part IV.A.2.c.2.a. 415See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; BDA (Feb. 2012); RBC. Another commenter requested that this requirement be eliminated or changed to ‘‘underwriting activities of the banking entity with respect to the covered financial position must be designed to meet the near-term demands of clients, customers, or counterparties.’’ See Japanese Bankers Ass’n. 416See RBC (stating that the Board has found acceptable the retention of assets acquired in connection with underwriting activities for a period of 90 to 180 days and has further permitted holding periods of up to a year in certain circumstances, such as for less liquid securities). 417See AFR et al. (Feb. 2012); Sens. Merkley & Levin (Feb. 2012). 418See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; BDA (Feb. 2012); RBC. 419See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; RBC. These commenters generally stated that an underwriter for a ‘‘bought deal’’ may end up with an unsold allotment because, pursuant to this type of offering, an underwriter makes a commitment to purchase securities from an issuer or selling security holder, without pre-commitment marketing to gauge customer interest, in order to provide greater speed and certainty of execution. See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC. 420See SIFMA et al. (Prop. Trading) (Feb. 2012) (representing that because an underwriter generally backstops a rights offering by committing to exercise any rights not exercised by shareholders, the underwriter may end up holding a residual portion of the offering if investors do not exercise all of the rights). 421See BDA (Feb. 2012). This commenter stated that underwriters frequently underwrite bonds in the fixed-income market knowing that they may need to retain unsold allotments in their inventory. The commenter indicated that this scenario arises because the fixed-income market is not as deep as other markets, so underwriters frequently cannot sell bonds when they go to market; instead, the underwriters will retain the bonds until a sufficient amount of liquidity is available in the market. See id. 422See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA. 423See BoA; RBC; LSTA (Feb. 2012). One of these commenters stated that, in the case of securities issued in lieu of or to refinance bridge loan facilities, market conditions or investor demand may change during the period of time between extension of the bridge commitment and when the bridge loan is required to be funded or such securities are required to be issued. As a result, this commenter requested that the near term demands of clients, customers, or counterparties be measured at the time of the initial extension of the bridge commitment. See LSTA (Feb. 2012). 424See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC. 425See AFR et al. (Feb. 2012); CalPERS; Occupy; Public Citizen; Goldman (Prop. Trading);
Fidelity; Japanese Bankers Ass’n.; Sens. Merkley & Levin (Feb. 2012); Alfred Brock. 426See AFR et al. (Feb. 2012); CalPERS; Occupy; Public Citizen; Alfred Brock. 427See AFR et al. (Feb. 2012) (recognizing, however, that a small portion of an underwriting may occasionally be ‘‘hung’’); CalPERS; Occupy (stating that a banking entity’s retention of unsold allotments may result in potential conflicts of interest). 428See AFR et al. (Feb. 2012). 429See Occupy (stating that the meaning of the term ‘‘substantial’’ would depend on the circumstances of the particular offering). 430See CalPERS. 431See Goldman (Prop. Trading); Fidelity (expressing concern that this may result in a more concentrated supply of securities and, thus, decrease the opportunity for diversification in the portfolios of shareholders’ funds). 432See Goldman (Prop. Trading). financial position be designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties.413 b. Comments Regarding the Proposed Near Term Customer Demand Requirement Both the statute and the proposed rule require a banking entity’s underwriting activity to be ‘‘designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties.’’ 414 Several commenters requested that this standard be interpreted in a flexible manner to allow a banking entity to participate in an offering that may require it to retain an unsold allotment for a period of time.415 In addition, one commenter stated that the final rule should provide flexibility in this standard by recognizing that the concept of ‘‘near term’’ differs between asset classes and depends on the liquidity of the market.416 Two commenters expressed views on how the near term customer demand requirement should work in the context of a securitization or creating what the commenters characterized as ‘‘structured products’’ or ‘‘structured instruments.’’ 417 Many commenters expressed concern that the proposed requirement, if narrowly interpreted, could prevent an underwriter from holding a residual position for which there is no immediate demand from clients, customers, or counterparties.418 Commenters noted that there are a variety of offerings that present some risk of an underwriter having to hold a residual position that cannot be sold in the initial distribution, including ‘‘bought deals,’’ 419 rights offerings,420 and fixed-income offerings.421 A few commenters noted that similar scenarios can arise in the case of an AP creating more shares of an ETF than it can sell 422 and bridge loans.423 Two commenters indicated that if the rule does not provide greater clarity and flexibility with respect to the near term customer demand requirement, a banking entity may be less inclined to participate in a distribution where there is the potential risk of an unsold allotment, may price such risk into the fees charged to underwriting clients, or may be forced into a ‘‘fire sale’’ of the unsold allotment.424
Several other commenters provided views on whether a banking entity should be able to hold a residual position from an offering pursuant to the underwriting exemption, although they did not generally link their comments to the proposed near term demand requirement.425 Many of these commenters expressed concern about permitting a banking entity to retain a portion of an underwriting and noted potential risks that may arise from such activity.426 For example, some of these commenters stated that retention or warehousing of underwritten securities can be an indication of impermissible proprietary trading intent (particularly if systematic), or may otherwise result in high-risk exposures or conflicts of interests.427 One of these commenters recommended the Agencies use a metric to monitor the size of residual positions retained by an underwriter,428 while another commenter suggested adding a requirement to the proposed exemption to provide that a ‘‘substantial’’ unsold or retained allotment would be an indication of prohibited proprietary trading.429 Similarly, one commenter recommended that the Agencies consider whether there are sufficient provisions in the proposed rule to reduce the risks posed by banking entities retaining or warehousing underwritten instruments, such as subprime mortgages, collateralized debt obligation tranches, and high yield debt of leveraged buyout issuers, which poses heightened financial risk at the top of economic cycles.430 Other commenters indicated that undue restrictions on an underwriter’s ability to retain a portion of an offering may result in certain harms to the capital-raising process. These commenters represented that unclear or negative treatment of residual positions will make banking entities averse to the risk of an unsold allotment, which may result in banking entities underwriting smaller offerings, less capital generation for issuers, or higher underwriting discounts, which would increase the cost of raising capital for businesses.431 One of these commenters suggested that a banking entity be permitted to hold a residual position under the underwriting exemption as long as it continues to take reasonable steps to attempt to dispose of the residual position in light of existing market conditions.432 In addition, in response to a question in the proposal, one commenter

433See Japanese Bankers Ass’n.
434See Sens. Merkley & Levin (Feb. 2012). 435See AFR et al. (Feb. 2012); Sens. Merkley & Levin (Feb. 2012). 436See AFR et al. (Feb. 2012) 437See Sens. Merkley & Levin (Feb. 2012). 438See Banco de Me´xico. 439See SIFMA et al. (Prop. Trading) (Feb. 2012); IIB/EBF. One of these commenters represented that many banking entities serve as primary dealers in jurisdictions in which they operate, and primary dealers often: (i) Are subject to minimum purchase and other obligations in the jurisdiction’s foreign sovereign debt; (ii) play important roles in underwriting and market making in State, provincial, and municipal debt issuances; and (iii) act as intermediaries through which a government’s financial and monetary policies operate. This commenter stated that, due to these considerations, restrictions on the ability of banking entities to act as primary dealer are likely to harm the governments they serve. See IIB/EBF. 440Final rule §ll.4(a)(2)(ii). 441The proposed rule required the underwriting activities of the banking entity with respect to the covered financial position to be designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties. See proposed rule §ll.4(a)(2)(v). 442See supra Part IV.A.2.c.2.b. (discussing commenters’ concerns that the proposed near term customer demand requirement may limit a banking entity’s ability to retain an unsold allotment). 443A banking entity may not structure a complex instrument on its own initiative using the underwriting exemption. It may use the underwriting exemption only with respect to distributions of securities that comply with the final rule. The Agencies believe this requirement addresses one commenter’s concern that a banking entity could rely on the underwriting exemption without regard to anticipated customer demand. See AFR et al. (Feb. 2012) In addition, a trading desk hedging the risks of an underwriting position in a complex, novel instrument must comply with the hedging exemption in the final rule. 444An issuer or selling security holder for purposes of this rule may include, among others, corporate issuers, sovereign issuers for which the banking entity acts as primary dealer (or functional equivalent), or any other person that is an issuer, as defined in final rule §ll.3(e)(9), or a selling security holder, as defined in final rule §ll .4(a)(5). The Agencies believe that the underwriting exemption in the final rule should generally allow a primary dealer (or functional equivalent) to act as an underwriter for a sovereign government’s issuance of its debt because, similar to other underwriting activities, this involves a banking entity agreeing to distribute securities for an issuer (in this case, the foreign sovereign) and engaging in a distribution of such securities. See SIFMA et al. (Prop. Trading) (Feb. 2012); IIB/EBF; Banco de Me´xico. A banking entity acting as primary dealer (or functional equivalent) may also be able to rely on the
market-making exemption or other exemptions for some of its activities. See infra Part IV.A.3.c.2.c. The final rule defines ‘‘client, customer, or counterparty’’ for purposes of the underwriting exemption as ‘‘market participants that may transact with the banking entity in connection with a particular distribution for which the banking entity is acting as underwriter.’’ Final rule §ll.4(a)(7). 445One commenter stated that, in the case of a securitization, an underwriting should be seen as a distribution of all, or nearly all, of the securities related to a securitization (excluding the amount required for credit risk retention purposes) along a time line designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties. See Sens. Merkley & Levin (Feb. 2012). The final rule’s near term customer demand requirement considers the liquidity, maturity, and depth of the market for the type of security and recognizes that the amount of time a trading desk may need to hold an underwriting position may vary based on these factors. The final rule does not, however, adopt a standard that applies differently based solely on the particular type of security being distributed (e.g., an asset-backed security versus an equity security) or that precludes certain types of securities from being distributed by a banking entity acting as an underwriter in accordance with the expressed the view that the rule should not require documentation with respect to residual positions held by an underwriter.433 In the case of securitizations, one commenter stated that if the underwriter wishes to retain some of the securities or bonds in its longer-term investment book, such decisions should be made by a separate officer, subject to different standards and compensation.434 Two commenters discussed how the near term customer demand requirement should apply in the context of a banking entity acting as an underwriter for a securitization or structured product.435 One of these commenters indicated that the near term demand requirement should be interpreted to require that a distribution of securities facilitate pre-existing client demand. This commenter stated that a banking entity should not be considered to meet the terms of the proposed requirement if, on the firm’s own initiative, it designs and structures a complex, novel instrument and then seeks customers for the instrument, while retaining part of the issuance on its own book. The commenter further emphasized that underwriting should involve two-way demand—clients who want assistance in marketing their securities and customers who may wish to purchase the securities—with the banking entity serving as an intermediary.436 Another commenter indicated that an underwriting should likely be seen as a distribution of all, or nearly all, of the securities related to a securitization (excluding any amount required for credit risk retention purposes) along a time line designed not to exceed
reasonably expected near term demands of clients, customers, or counterparties. According to the commenter, this approach would serve to minimize the arbitrage and risk concentration possibilities that can arise through the securitization and sale of some tranches and the retention of other tranches.437 One commenter expressed concern that the proposed near term customer demand requirement may impact a banking entity’s ability to act as primary dealer because some primary dealers are obligated to bid on each issuance of a government’s sovereign debt, without regard to expected customer demand.438 Two other commenters expressed general concern that the proposed underwriting exemption may be too narrow to permit banking entities that act as primary dealers in or for foreign jurisdictions to continue to meet the relevant jurisdiction’s primary dealer requirements.439
c. Final Near Term Customer Demand
Requirement
The final rule requires that the amount and types of the securities in the trading desk’s underwriting position be designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties, and reasonable efforts be made to sell or otherwise reduce the underwriting position within a reasonable period, taking into account the liquidity, maturity, and depth of the market for the relevant type of security.440 As noted above, the near term demand standard originates from section 13(d)(1)(B) of the BHC Act, and a similar requirement was included in the proposed rule.441 The Agencies are making certain modifications to the proposed approach in response to comments. In particular, the Agencies are clarifying the operation of this requirement, particularly with respect to unsold allotments.442 Under this requirement, a trading desk must have a reasonable expectation of demand from other market participants for the amount and type of securities to be acquired from an issuer or selling security holder for distribution.443 Such reasonable expectation may be based on factors such as current market conditions and prior experience with similar offerings of securities. A banking entity is not required to engage in bookbuilding or similar marketing efforts to determine investor demand for the securities pursuant to this requirement, although such efforts may form the basis for the trading desk’s reasonable expectation of demand. While an issuer or selling security holder can be considered to be a client, customer, or counterparty of a banking entity acting as an underwriter for its distribution of securities, this requirement cannot be met by accounting solely for the issuer’s or selling security holder’s desire to sell the securities.444 However, the expectation of demand does not require a belief that the securities will be placed immediately. The time it takes to carry out a distribution may differ based on the liquidity, maturity, and depth of the market for the type of security.445

requirements of this exemption because the Agencies believe the statute is best read to permit a banking entity to engage in underwriting activity to facilitate distributions of securities by issuers and selling security holders, regardless of type, to provide client-oriented financial services. That reading is consistent with the statute’s language and finds support in the legislative history. See 156 Cong. Rec. S5895–S5896 (daily ed. July 15, 2010) (statement of Sen. Merkley) (stating that the underwriting exemption permits ‘‘transactions that are technically trading for the account of the firm but, in fact, facilitate the provision of near-term client-oriented financial services’’). In addition, with respect to this commenter’s statement regarding credit risk retention requirements, the Agencies note that compliance with the credit risk retention requirements of Section 15G of the Exchange Act would not impact the availability of the underwriting exemption in the final rule. 446This approach should help address commenters’ concerns that an inflexible interpretation of the near term demand requirement could result in fire sales, higher fees for underwriting services, or reluctance to act as an underwriter for certain types of distributions that present a greater risk of unsold allotments. See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC. Further, the Agencies believe this should reduce commenters’ concerns that, to the extent a delayed distribution of securities, which are acquired as a result of an outstanding bridge loan, is able to qualify for the underwriting exemption, a stringent interpretation of the near term demand requirement could prevent a banking entity from retaining such securities if market conditions are suboptimal or marketing efforts are not entirely successful. See RBC; BoA; LSTA (Feb. 2012). In response to one commenter’s request that the Agencies allow a banking entity to assess near term demand at the time of the initial extension of the bridge commitment, the Agencies believe it could be appropriate to determine whether the banking entity has a reasonable expectation of demand from other market participants for the amount and type of securities to be acquired at that time, but note that the trading desk would continue to be subject to the requirement to make reasonable efforts to sell the resulting underwriting position at the time of the initial distribution and for the remaining time the securities are in its inventory. See LSTA (Feb. 2012). 447The Agencies believe that requiring a trading desk to make reasonable efforts to sell or otherwise reduce its underwriting position addresses commenters’ concerns about the risks associated with unsold allotments or the retention of underwritten instruments because this requirement is designed to prevent a trading desk from retaining an unsold allotment for speculative purposes when there is customer buying interest for the relevant security at commercially reasonable prices.
Thus, the Agencies believe this obviates the need for certain additional requirements suggested by commenters. See, e.g., Occupy; AFR et al. (Feb. 2012); CalPERS. The final rule strikes an appropriate balance between the concerns raised by these commenters and those noted by other commenters regarding the potential market impacts of strict requirements against holding an unsold allotment, such as higher fees to underwriting clients, fire sales of unsold allotments, or general reluctance to participate in any distribution that presents a risk of an unsold allotment. The requirement to make reasonable efforts to sell or otherwise reduce the underwriting position should not cause the market impacts predicted by these commenters because it does not prevent an underwriter from retaining an unsold allotment for a reasonable period or impose strict holding period limits on unsold allotments. See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; Goldman (Prop. Trading); Fidelity. 448This approach is generally consistent with one commenter’s suggested approach to addressing the issue of unsold allotments. See, e.g., Goldman (Prop. Trading) (suggesting that a banking entity be permitted to hold a residual position under the underwriting exemption as long as it continues to take reasonable steps to attempt to dispose of the residual position in light of existing market conditions). In addition, allowing an underwriter to retain an unsold allotment under certain circumstances is consistent with the proposal. See Joint Proposal, 76 FR 68,867 (‘‘There may be circumstances in which an underwriter would hold securities that it could not sell in the distribution for investment purposes. If the acquisition of such unsold securities were in connection with the underwriting pursuant to the permitted underwriting activities exemption, the underwriter would also be able to dispose of such securities at a later time.’’); CFTC Proposal, 77 FR 8352. A number of commenters raised questions about whether the rule would permit retaining an unsold allotment. See Goldman (Prop. Trading); Fidelity; SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; RBC; AFR et al. (Feb. 2012); CalPERS; Occupy; Public Citizen; Alfred Brock. 449See Goldman (Prop. Trading); Fidelity. 450See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; RBC. 451See AFR et al. (Feb. 2012); CalPERS; Occupy; Public Citizen; Alfred Brock. 452To the extent that an AP for an ETF is able to meet the terms of the underwriting exemption for its activity, it may be able to retain ETF shares that it created if it had a reasonable expectation of buying interest in the ETF shares and engages in reasonable efforts to sell the ETF shares. See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA. 453See Goldman (Prop. Trading); Fidelity; SIFMA et al. (Prop. Trading) (Feb. 2012); RBC. 454See AFR et al. (Feb. 2012); CalPERS; Occupy. This requirement is not intended to prevent a trading desk from distributing an offering over a reasonable time
consistent with market conditions or from retaining an unsold allotment of the securities acquired from an issuer or selling security holder where holding such securities is necessary due to circumstances such as less-thanexpected purchaser demand at a given price.446 An unsold allotment is, however, subject to the requirement to make reasonable efforts to sell or otherwise reduce the underwriting position.447 The definition of ‘‘underwriting position’’ includes, among other things, any residual position from the distribution that is managed by the trading desk. The final rule includes the requirement to make reasonable efforts to sell or otherwise reduce the trading desk’s underwriting position in order to respond to comments on the issue of when a banking entity may retain an unsold allotment when it is acting as an underwriter, as discussed in more detail below, and ensure that the exemption is available only for activities that involve underwriting activities, and not prohibited proprietary trading.448 As a general matter, commenters expressed differing views on whether an underwriter should be permitted to hold an unsold allotment for a certain period of time after the initial distribution. For example, a few commenters suggested that limitations on retaining an unsold allotment would increase the cost of raising capital 449 or would negatively impact certain types of securities offerings (e.g., bought deals, rights offerings, and fixed-income offerings).450 Other commenters, however, expressed concern that the proposed exemption would allow a banking entity to retain a portion of a distribution for speculative purposes.451 The Agencies believe the requirement to make reasonable efforts to sell or otherwise reduce the underwriting position appropriately addresses both sets of comments. More specifically, this standard clarifies that an underwriter generally may retain an unsold allotment that it was unable to sell to purchasers as part of the initial distribution of securities, provided it had a reasonable expectation of buying interest and engaged in reasonable selling efforts.452 This should reduce the potential for the negative impacts of a more stringent approach predicted by commenters, such as increased fees for underwriting, greater costs to businesses for raising capital, and potential fire sales of unsold allotments.453 However, to address concerns that a banking entity may retain an unsold allotment for purely speculative purposes, the Agencies are requiring that reasonable efforts be made to sell or otherwise reduce the underwriting position, which includes any unsold allotment, within a reasonable period. The Agencies agree with these commenters that systematic retention of an underwriting position, without engaging in efforts to sell the position and without regard to whether the trading desk is able to sell the securities at a commercially reasonable price, would be indicative of impermissible proprietary trading intent.454
The Agencies recognize that the meaning of ‘‘reasonable period’’ may differ based on the liquidity, maturity, and depth of the market for the relevant type of securities. For example, an underwriter may be more likely to retain an unsold allotment in a bond offering because liquidity in the fixed-income market is generally not as deep as that in the equity market. If a trading desk retains an underwriting position for a period of time after the distribution, the trading desk must manage the risk of its underwriting position in accordance with its inventory and risk limits and authorization procedures. As discussed above, hedging transactions undertaken in connection with such risk management activities must be conducted in compliance with the

455The trading desk’s retention and sale of the unsold allotment must comply with the federal securities laws and regulations, but is otherwise permitted under the underwriting exemption. 456See supra note 403. 457For example, some commenters suggested that the proposed underwriting exemption could have a chilling effect on banking entities’ willingness to engage in underwriting activities. See, e.g., Lord Abbett; Fidelity. Further, some commenters expressed concern that the proposed near term customer demand requirement might negatively impact certain forms of capital-raising if the requirement is interpreted narrowly or inflexibly. See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; BDA (Feb. 2012); RBC. 458See proposed rule §ll.4(a)(2)(i). 459See Joint Proposal, 76 FR 68,866; CFTC Proposal, 77 FR 8352. 460The independent testing standard is discussed in more detail in Part IV.C., which discusses the compliance program requirement in §ll.20 of the final rule. 461See final rule §ll.4(a)(2)(iii)(A). 462See final rule §ll.4(a)(2)(iii)(B). A trading desk must have limits on the amount, types, and risk of the securities in its underwriting position, level of exposures to relevant risk factors arising from its underwriting position, and period of time a security may be held. See id. 463See final rule §ll.4(a)(2)(iii)(C). 464See final rule §ll.4(a)(2)(iii)(D). 465See Joint Proposal, 76 FR 68,963–68,967 (requiring certain banking entities to establish, maintain, and enforce compliance programs with, among other things: (i) Written policies and procedures that describe a trading unit’s authorized instruments and products; (ii) internal controls for each trading unit, including risk limits for each trading unit and surveillance procedures; and (iii) a management framework, including management procedures for overseeing compliance with the proposed rule). hedging exemption in §ll.5 of the final rule. The Agencies emphasize that the requirement to make reasonable efforts to sell or otherwise reduce the underwriting position applies to the entirety of the trading desk’s underwriting position. As a result, this requirement applies to a number of different scenarios in which an underwriter may hold a long or short position in the securities that are the subject of a distribution for a period of time. For example, if an underwriter is facilitating a distribution of securities for which there is sufficient investor demand to purchase the securities at the offering price, this requirement would prevent the underwriter from retaining a portion of the allotment for its own account instead of selling the securities to interested investors. If instead there was insufficient investor demand at the time of the initial offering, this requirement would recognize that it may be appropriate for the underwriter to hold an unsold allotment for a reasonable period of time. Under these circumstances, the underwriter would need to make reasonable efforts to sell the unsold
allotment when there is sufficient market demand for the securities.455 This requirement would also apply in situations where the underwriters sell securities in excess of the number of securities to which the underwriting commitment relates, resulting in a syndicate short position in the same class of securities that were the subject of the distribution.456 This provision of the final exemption would require reasonable efforts to reduce any portion of the syndicate short position attributable to the banking entity that is acting as an underwriter. Such reduction could be accomplished if, for example, the managing underwriter exercises an overallotment option or shares are purchased in the secondary market to cover the short position. The near term demand requirement, including the requirement to make reasonable efforts to reduce the underwriting position, represents a new regulatory requirement for banking entities engaged in underwriting. At the margins, this requirement could alter the participation decision for some banking entities with respect to certain types of distributions, such as distributions that are more likely to result in the banking entity retaining an underwriting position for a period of time.457 However, the Agencies recognize that liquidity, maturity, and depth of the market vary across types of securities, and the Agencies expect that the express recognition of these differences in the rule should help mitigate any incentive to exit the underwriting business for certain types of securities or types of distributions.
3. Compliance Program Requirement
a. Proposed Compliance Program Requirement
Section ll.4(a)(2)(i) of the proposed
exemption required a banking entity to establish an internal compliance program, as required by §ll.20 of the proposed rule, that is designed to ensure the banking entity’s compliance with the requirements of the underwriting exemption, including reasonably designed written policies and procedures, internal controls, and independent testing.458 This requirement was proposed so that any banking entity relying on the underwriting exemption would have reasonably designed written policies and procedures, internal controls, and independent testing in place to support its compliance with the terms of the exemption.459 b. Comments on the Proposed Compliance Program Requirement Commenters did not directly address the proposed compliance program requirement in the underwriting exemption. Comments on the proposed compliance program requirement of § ll.20 of the proposed rule are discussed in Part IV.C., below.
c. Final Compliance Program
Requirement
The final rule includes a compliance program requirement that is similar to the proposed requirement, but the Agencies are making certain enhancements to emphasize the importance of a strong internal compliance program. More specifically, the final rule requires that a banking entity’s compliance program specifically include reasonably designed written policies and procedures, internal controls, analysis and independent testing 460 identifying and addressing: (i) The products, instruments or exposures each trading desk may purchase, sell, or manage as part of its underwriting activities; 461 (ii) limits for each trading desk, based on the nature and amount of the trading desk’s underwriting activities, including the reasonably expected near term demands of clients, customers, or counterparties; 462 (iii) internal controls and ongoing monitoring and analysis of each trading desk’s compliance with its limits; 463 and (iv) authorization procedures, including escalation procedures that require review and approval of any trade that would exceed one or more of a trading desk’s limits, demonstrable analysis of the basis for any temporary or permanent increase to one or more of a trading desk’s limits, and independent review (i.e., by risk managers and compliance officers at the appropriate level independent of the trading desk) of such demonstrable analysis and approval.464 As noted above, the proposed compliance program requirement did not include the four specific elements listed above in the proposed underwriting exemption, although each of these provisions was included in some form in the detailed compliance program requirement under Appendix C of the proposed rule.465 The Agencies are moving these particular requirements, with certain enhancements, into the underwriting exemption because the Agencies believe these are core elements of a program to ensure compliance with the underwriting exemption. These compliance procedures must be established, implemented, maintained, and enforced for each trading desk engaged in underwriting activity under § ll.4(a) of the final rule. Each of the

466See final rule §§ll.4(a)(2)(iii), ll.4(b)(2)(iii). 467See final rule §ll.5. 468See final rule §ll.4(a)(2)(iii)(C). 469See final rule §ll.4(a)(2)(iii)(D). 470See Part IV.C. (discussing the compliance program requirement in §ll.20 of the final rule). 471See proposed rule §ll.4(a)(2)(vii); Joint Proposal, 76 FR 68,868; CFTC Proposal, 77 FR 8353. 472See id. 473See Occupy; AFR et al. (Feb. 2012); Better Markets (Feb. 2012). 474See AFR et al. (Feb. 2012). 475See Occupy. requirements in paragraphs (a)(2)(iii)(A) through (D) must be appropriately tailored to the individual trading activities and strategies of each trading desk. The compliance program requirement in the underwriting exemption is substantially similar to the compliance program requirement in the marketmaking exemption, except that the Agencies are requiring more detailed risk management procedures in the market-making exemption due to the nature of that activity.466 The Agencies believe including similar compliance program requirements in the underwriting and market-making exemptions may reduce burdens associated with building and maintaining compliance programs for each trading desk. Identifying in the compliance program the relevant products, instruments, and exposures in which a trading desk is permitted to trade will facilitate monitoring and oversight of compliance with the underwriting exemption. For example, this requirement should prevent an individual trader on an underwriting desk from establishing positions in instruments that are unrelated to the desk’s underwriting function. Further, the identification of permissible products, instruments, and exposures will help form the basis for the specific types of position and risk limits that the banking entity must establish and is relevant to considerations throughout the exemption regarding the liquidity, maturity, and depth of the market for the relevant type of security. A trading desk must have limits on the amount, types, and risk of the securities in its underwriting position, level of exposures to relevant risk factors arising from its underwriting position, and period of time a security may be held. Limits established under this provision, and any modifications to these limits made through the required escalation procedures, must account for the nature and amount of the trading desk’s underwriting activities, including the reasonably expected near term demands of clients, customers, or counterparties. Among other things, these limits should be designed to prevent a trading desk from systematically retaining unsold allotments even when there is customer demand for the positions that remain in the trading desk’s inventory. The Agencies recognize that trading desks’ limits may differ across types of securities and acknowledge that trading desks engaged in underwriting activities in less liquid securities, such as corporate bonds, may require different inventory, risk exposure, and holding period limits than trading desks
engaged in underwriting activities in more liquid securities, such as certain equity securities. A trading desk hedging the risks of an underwriting position must comply with the hedging exemption, which provides for compliance procedures regarding risk management.467 Furthermore, a banking entity must establish internal controls and ongoing monitoring and analysis of each trading desk’s compliance with its limits, including the frequency, nature, and extent of a trading desk exceeding its limits.468 This may include the use of management and exception reports. Moreover, the compliance program must set forth a process for determining the circumstances under which a trading desk’s limits may be modified on a temporary or permanent basis (e.g., due to market changes). As noted above, a banking entity’s compliance program for trading desks engaged in underwriting activity must also include escalation procedures that require review and approval of any trade that would exceed one or more of a trading desk’s limits, demonstrable analysis that the basis for any temporary or permanent increase to one or more of a trading desk’s limits is consistent with the near term customer demand requirement, and independent review of such demonstrable analysis and approval.469 Thus, to increase a limit of a trading desk, there must be an analysis of why such increase would be appropriate based on the reasonably expected near term demands of clients, customers, or counterparties, which must be independently reviewed. A banking entity also must maintain documentation and records with respect to these elements, consistent with the requirement of § ll.20(b)(6). As discussed in more detail in Part IV.C., the Agencies recognize that the compliance program requirements in the final rule will impose certain costs on banking entities but, on balance, the Agencies believe such requirements are necessary to facilitate compliance with the statute and the final rule and to reduce the risk of evasion.470
4. Compensation Requirement
a. Proposed Compensation Requirement Another provision of the proposed underwriting exemption required that the compensation arrangements of persons performing underwriting activities at the banking entity must be designed not to encourage proprietary risk-taking.471 In connection with this requirement, the proposal clarified that although a banking entity relying on the underwriting exemption may appropriately take into account revenues resulting from movements in the price of securities that the banking entity underwrites to the extent that such revenues reflect the effectiveness with which personnel have managed underwriting risk, the banking entity should provide compensation incentives that primarily reward client revenues and effective client service, not proprietary risk-taking.472 b. Comments on the Proposed Compensation Requirement A few commenters expressed general support for the proposed requirement, but suggested certain modifications that they believed would enhance the requirement and make it more effective.473 Specifically, one commenter suggested tailoring the requirement to underwriting activity by, for example, ensuring that personnel involved in underwriting are given compensation incentives for the successful distribution of securities off the firm’s balance sheet and are not rewarded for profits associated with securities that are not successfully distributed (although losses from such positions should be taken into consideration in determining the employee’s compensation). This commenter further recommended that bonus compensation for a deal be withheld until all or a high percentage of the relevant securities are distributed.474 Finally, one commenter suggested that the term ‘‘designed’’ should be removed from this provision.475
c. Final Compensation Requirement
Similar to the proposed rule, the underwriting exemption in the final rule requires that the compensation arrangements of persons performing the banking entity’s underwriting activities, as described in the exemption, be

476See final rule §ll.4(a)(2)(iv); proposed rule §ll.4(a)(2)(vii). This is consistent with the final compensation requirements in the market-making and hedging exemptions. See final rule §ll .4(b)(2)(v); final rule §ll.5(b)(3). 477See AFR et al. (Feb. 2012); supra Part IV.A.2.c.2.c. (discussing the requirement to make reasonable efforts to sell or otherwise reduce the underwriting position). 478See AFR et al. (Feb. 2012). 479See Occupy. 480See proposed rule §ll.4(a)(2)(iv); Joint Proposal, 76 FR 68,867; CFTC Proposal, 77 FR 8353. The proposal clarified that, in the case of a financial institution that is a government securities dealer, such institution must have filed notice of that status as required by section 15C(a)(1)(B) of the Exchange Act. See Joint Proposal, 76 FR 68,867; CFTC Proposal, 77 FR 8353. 481See Part IV.A.3.c.6. (discussing the registration requirement in the market-making exemption). 482For example, if a banking entity is a bank engaged in underwriting asset-backed securities for which it would be required to register as a securities dealer but for the exclusion contained in
section 3(a)(5)(C)(iii) of the Exchange Act, the final
rule would not require the banking entity to be a registered securities dealer to underwrite the assetbacked securities. See 15 U.S.C. 78c(a)(5)(C)(iii). designed not to reward or incentivize prohibited proprietary trading.476 The Agencies do not intend to preclude an employee of an underwriting desk from being compensated for successful underwriting, which involves some risktaking. Consistent with the proposal, activities for which a banking entity has established a compensation incentive structure that rewards speculation in, and appreciation of, the market value of securities underwritten by the banking entity are inconsistent with the underwriting exemption. A banking entity may, however, take into account revenues resulting from movements in the price of securities that the banking entity underwrites to the extent that such revenues reflect the effectiveness with which personnel have managed underwriting risk. The banking entity should provide compensation incentives that primarily reward client revenues and effective client services, not prohibited proprietary trading. For example, a compensation plan based purely on net profit and loss with no consideration for inventory control or risk undertaken to achieve those profits would not be consistent with the underwriting exemption. The Agencies are not adopting an approach that prevents an employee from receiving any compensation related to profits arising from an unsold allotment, as suggested by one commenter, because the Agencies believe the final rule already includes sufficient controls to prevent a trading desk from intentionally retaining an unsold allotment to make a speculative profit when such allotment could be sold to customers.477 The Agencies also are not requiring compensation to be vested for a period of time, as recommended by one commenter to reduce traders’ incentives for undue risk-taking. The Agencies believe the final rule includes sufficient controls around risk-taking activity without a compensation vesting requirement because a banking entity must establish limits for a trading desk’s underwriting position and the trading desk must make reasonable efforts to sell or otherwise reduce the underwriting position within a reasonable period.478 The Agencies continue to believe it is appropriate to focus on the design of a banking entity’s compensation structure, so the Agencies are not removing the term ‘‘designed’’ from this provision.479 This retains an objective focus on actions that the banking entity can control—the design of its incentive compensation program—and avoids a subjective focus on whether an employee feels incentivized by compensation, which may be more difficult to assess. In addition, the framework of the final compensation requirement will allow banking entities to better plan and control the design of their compensation arrangements, which should reduce costs and uncertainty and enhance monitoring, than an approach focused solely on individual
outcomes.
5. Registration Requirement
a. Proposed Registration Requirement
Section ll.4(a)(2)(iv) of the
proposed rule would have required that a banking entity have the appropriate dealer registration or be exempt from registration or excluded from regulation as a dealer to the extent that, in order to underwrite the security at issue, a person must generally be a registered securities dealer, municipal securities dealer, or government securities dealer.480 Further, if the banking entity was engaged in the business of a dealer outside the United States in a manner for which no U.S. registration is required, the proposed rule would have required the banking entity to be subject to substantive regulation of its dealing business in the jurisdiction in which the business is located. b. Comments on Proposed Registration Requirement Commenters generally did not address the proposed dealer requirement in the underwriting exemption. However, as discussed below in Part IV.A.3.c.2.b., a number of commenters addressed a similar requirement in the proposed market-making exemption.
c. Final Registration Requirement
The requirement in §ll.4(a)(2)(vi) of the underwriting exemption, which provides that the banking entity must be licensed or registered to engage in underwriting activity in accordance with applicable law, is substantively similar to the proposed dealer registration requirement in § ll .4(a)(2)(iv) of the proposed rule. The primary difference between the proposed requirement and the final requirement is that the Agencies have simplified the language of the rule. The Agencies have also made conforming changes to the corresponding requirement in the market-making exemption to promote consistency across the exemptions, where appropriate.481 As was proposed, this provision will require a U.S. banking entity to be an SEC-registered dealer in order to rely on the underwriting exemption in connection with a distribution of securities—other than exempted securities, security-based swaps, commercial paper, bankers acceptances or commercial bills—unless the banking entity is exempt from registration or excluded from regulation as a dealer.482 To the extent that a banking entity relies on the underwriting exemption in connection with a distribution of municipal securities or government securities, rather than the exemption in § ll.6(a) of the final rule, this provision may require the banking entity to be registered or licensed as a municipal securities dealer or government securities dealer, if required by applicable law. However, this provision does not require a banking entity to register in order to qualify for the underwriting exemption if the banking entity is not otherwise required to register by applicable law. The Agencies have determined that, for purposes of the underwriting exemption, rather than require a banking entity engaged in the business of a securities dealer outside the United States to be subject to substantive regulation of its dealing business in the jurisdiction in which the business is located, a banking entity’s dealing activity outside the U.S. should only be subject to licensing or registration provisions if required under applicable foreign law (provided no U.S. registration or licensing requirements apply to the banking entity’s activities). In response to comments, the final rule recognizes that certain foreign jurisdictions may not provide for substantive regulation of dealing

483See infra Part IV.A.3.c.6.c. (discussing comments on this issue with respect to the proposed dealer registration requirement in the market-making exemption). 484See proposed rule §ll.4(a)(2)(vi); Joint Proposal, 76 FR 68,867–68,868; CFTC Proposal, 77 FR 8353. 485See Joint Proposal, 76 FR 68,867–68,868 n.142; CFTC Proposal, 77 FR 8353 n.148. 486See Joint Proposal, 76 FR 68,867–68,868; CFTC Proposal, 77 FR 8353. 487See Goldman (Prop. Trading); Occupy; Sens. Merkley & Levin (Feb. 2012). 488See Banco de Me´xico (stating that primary dealers need to profit from resulting proprietary positions in foreign sovereign debt, including by holding significant positions in anticipation of future price movements, in order to make the primary dealer business financially attractive); IIB/ EBF (noting that primary dealers may actively seek to profit from price and interest rate movements of their holdings, which the relevant sovereign entity supports because such activity provides muchneeded liquidity for securities that are otherwise largely purchased pursuant to buy-and-hold strategies by institutional investors and other entities seeking safe returns and liquidity buffers); Japanese Bankers Ass’n. 489See Goldman (Prop. Trading). 490See Sens. Merkley & Levin (Feb. 2012). 491See Occupy (requesting that the rule require automatic disgorgement of any profits arising from appreciation in the value of positions in connection with underwriting activities). 492See AFR et al. (Feb. 2012); Public Citizen. 493See Goldman (Prop. Trading). 494See Banco de Me´xico; IIB/EBF; Japanese Bankers Ass’n. 495See Occupy; supra Part IV.A.2.c.2. (discussing comments on unsold allotments and the requirement in the final rule to make reasonable efforts to sell or otherwise reduce the underwriting position). 496See AFR et al. (Feb. 2012); Public Citizen. 497See supra Part IV.A.2.c.2. businesses.483 The Agencies do not believe it is necessary to preclude banking entities from engaging in underwriting activities in such foreign jurisdictions to achieve the goals of
section 13 of the BHC Act because these
banking entities would continue to be subject to the other requirements of the underwriting exemption.
6. Source of Revenue Requirement
a. Proposed Source of Revenue Requirement Under §ll.4(a)(2)(vi) of the proposed rule, the underwriting activities of a banking entity would have been required to be designed to generate revenues primarily from fees, commissions, underwriting spreads, or other income not attributable to appreciation in the value of covered financial positions or hedging of covered financial positions.484 The proposal clarified that underwriting spreads would include any ‘‘gross spread’’ (i.e., the difference between the price an underwriter sells securities to the public and the price it purchases them from the issuer) designed to compensate the underwriter for its services.485 This requirement provided that activities conducted in reliance on the underwriting exemption should demonstrate patterns of revenue generation and profitability consistent with, and related to, the services an underwriter provides to its customers in bringing securities to market, rather than changes in the market value of the underwritten securities.486 b. Comments on the Proposed Source of Revenue Requirement A few commenters requested certain modifications to the proposed source of revenue requirement. These commenters’ suggested revisions were generally intended either to refine the standard to better account for certain activities or to make it more stringent.487 Three commenters expressed concern that the proposed source of revenue requirement would negatively impact a banking entity’s ability to act as a primary dealer or in a similar capacity.488 With respect to suggested modifications, one commenter recommended that ‘‘customer revenue’’ include revenues attributable to syndicate activities, hedging activities, and profits and losses from sales of residual positions, as long as the underwriter makes a reasonable effort to dispose of any residual position in light of existing market conditions.489 Another commenter indicated that the rule would better address securitization if it required compensation to be linked in part to risk minimization for the securitizer and in part to serving customers. This commenter suggested that such a framework would be preferable because, in the context of securitizations, fee-based compensation structures did not previously prevent banking entities from accumulating large and risky positions with significant market exposure.490 To strengthen the proposed requirement, one commenter requested that the terms ‘‘designed’’ and ‘‘primarily’’ be removed and replaced by the word ‘‘solely.’’ 491 Two other commenters requested that this requirement be interpreted to prevent a banking entity from acting as an underwriter for a distribution of securities if such securities lack a discernible and sufficiently liquid preexisting market and a foreseeable market price.492
c. Final Rule’s Approach To Assessing
Source of Revenue
The Agencies believe the final rule includes sufficient controls around an underwriter’s source of revenue and have determined not to adopt the additional requirement included in proposed rule § ll.4(a)(2)(vi). The Agencies believe that removing this requirement addresses commenters’ concerns that the proposed requirement did not appropriately reflect certain revenue sources from underwriting activity 493 or may impact primary dealer activities.494 At the same time, the final rule continues to include provisions that focus on whether an underwriter is generating underwritingrelated revenue and that should limit an underwriter’s ability to generate revenues purely from price appreciation. In particular, the requirement to make reasonable efforts to sell or otherwise reduce the underwriting position within a reasonable period, which was not included in the proposed rule, should limit an underwriter’s ability to gain revenues purely from price appreciation related to its underwriter position. Similarly, the determination of whether an underwriter receives special compensation for purposes of the definition of ‘‘distribution’’ takes into account whether a banking entity is generating underwriting-related revenue. The final rule does not adopt a requirement that prevents an underwriter from generating any revenue from price appreciation out of concern that such a requirement could prevent an underwriter from retaining an unsold allotment under any circumstances, which would be inconsistent with other provisions of the exemption.495 Similarly, the Agencies are not adopting a source of revenue requirement that would prevent a banking entity from acting as underwriter for a distribution of securities if such securities lack a discernible and sufficiently liquid preexisting market and a foreseeable market price, as suggested by two commenters.496 The Agencies believe these commenters’ concern is mitigated by the near term demand requirement, which requires a trading desk to have a reasonable expectation of demand from other market participants for the amount and type of securities to be acquired from an issuer or selling security holder for distribution.497 Further, one commenter recommended a revenue requirement directed at securitization activities to prevent banking entities from accumulating large and risky positions with significant market

498See Sens. Merkley & Levin (Feb. 2012). 499See final rule §ll.4(a)(2)(ii). Further, as noted above, this exemption does not permit the accumulation of assets for securitization. See supra
Part IV.A.2.c.1.c.v.
500As discussed in Part IV.A.3.c.2.c.i., infra, the terms ‘‘client,’’ ‘‘customer,’’ and ‘‘counterparty’’ are defined in the same manner in the final rule. Thus, the Agencies use these terms synonymously throughout this discussion and sometimes use the term ‘‘customer’’ to refer to all entities that meet the definition of ‘‘client, customer, and counterparty’’ in the final rule’s market-making exemption. 501 12 U.S.C. 1851(d)(1)(B). 502See Joint Proposal, 76 FR 68,869; CFTC Proposal, 77 FR 8354–8355. 503See, e.g., SIFMA et al. (Prop. Trading) (Feb.
2012) (stating that the proposed exemption ‘‘seems
to view market making based on a liquid, exchangetraded equity model in which market makers are simple intermediaries akin to agents’’ and that ‘‘[t]his view does not fit market making even in equity markets and widely misses the mark for the vast majority of markets and asset classes’’); SIFMA (Asset Mgmt.) (Feb. 2012); Credit Suisse (Seidel); ICI (Feb. 2012); BoA; Columbia Mgmt.; Comm. on Capital Markets Regulation; Invesco; ASF (Feb.
2012) (‘‘The seven criteria in the proposed rule, and
the related criterion for identifying permitted hedging, are overly restrictive and will make it impractical for dealers to continue making markets in most securitized products.’’); Chamber (Feb.
2012) (expressing particular concern about the
commercial paper market).
504Several commenters stated that the proposed rule would limit a market maker’s ability to maintain inventory. See, e.g., NASP; Oliver Wyman (Dec. 2011); Wellington; Prof. Duffie; Standish Mellon; MetLife; Lord Abbett; NYSE Euronext; CIEBA; British Columbia; SIFMA et al. (Prop. Trading) (Feb. 2012); Shadow Fin. Regulatory Comm.; Credit Suisse (Seidel); Morgan Stanley; Goldman (Prop. Trading); BoA; STANY; SIFMA (Asset Mgmt.) (Feb. 2012); Chamber (Feb. 2012); IRSG; Abbott Labs et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012); Australian Bankers Ass’n. (Feb. 2012); FEI; ASF (Feb. 2012); RBC; PUC Texas; Columbia Mgmt.; SSgA (Feb. 2012); PNC et al.; Fidelity; ICI (Feb. 2012); British Bankers’ Ass’n.; Comm. on Capital Markets Regulation; IHS; Oliver Wyman (Feb. 2012); Thakor Study (stating that by artificially constraining the security holdings that a banking entity can have in its inventory for market making or proprietary trading purposes, section 13 of the BHC Act will make bank risk management less efficient and may adversely impact the diversified financial services business model of banks). However, some commenters stated that market makers should seek to minimize their inventory or should not need large inventories. See, exposure.498 The Agencies believe the requirement to make reasonable efforts to sell or otherwise reduce the underwriting position should achieve this stated goal and, thus, the Agencies do not believe an additional revenue requirement for securitization activity is needed.499
3. Section ll.4(b): Market-Making
Exemption a. Introduction In adopting the final rule, the Agencies are striving to balance two goals of section 13 of the BHC Act: To allow market making, which is important to well-functioning markets as well as to the economy, and simultaneously to prohibit proprietary trading, unrelated to market making or other permitted activities, that poses significant risks to banking entities and the financial system. In response to comments on the proposed marketmaking exemption, the Agencies are adopting certain modifications to the proposed exemption to better account for the varying characteristics of market making-related activities across markets and asset classes, while requiring that banking entities maintain a robust set of risk controls for their market makingrelated activities. A flexible approach to this exemption is appropriate because the activities a market maker undertakes to provide important intermediation and liquidity services will differ based on the liquidity, maturity, and depth of the market for a given type of financial instrument. The statute specifically permits banking entities to continue to provide these beneficial services to their clients, customers, and counterparties.500 Thus, the Agencies are adopting an approach that recognizes the full scope of market making-related activities banking entities currently undertake and requires that these activities be subject to clearly defined, verifiable, and monitored risk parameters. b. Overview

Proposed Market-Making Exemption
Section 13(d)(1)(B) of the BHC Act
provides an exemption from the prohibition on proprietary trading for the purchase, sale, acquisition, or disposition of securities, derivatives, contracts of sale of a commodity for future delivery, and options on any of the foregoing in connection with market making-related activities, to the extent that such activities are designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties.501
Section ll.4(b) of the proposed rule
would have implemented this statutory exemption by requiring that a banking entity’s market making-related activities comply with seven standards. As discussed in the proposal, these standards were designed to ensure that any banking entity relying on the exemption would be engaged in bona fide market making-related activities and, further, would conduct such activities in a way that was not susceptible to abuse through the taking of speculative, proprietary positions as a part of, or mischaracterized as, market making-related activities. The Agencies proposed to use additional regulatory and supervisory tools in conjunction with the proposed market-making exemption, including quantitative measurements for banking entities engaged in significant covered trading activity in proposed Appendix A, commentary on how the Agencies proposed to distinguish between permitted market making-related activity and prohibited proprietary trading in proposed Appendix B, and a compliance regime in proposed §ll .20 and, where applicable, Appendix C of the proposal. This multi-faceted approach was intended to address the complexities of differentiating permitted market making-related activities from prohibited proprietary trading.502
Comments on the Proposed MarketMaking Exemption
The Agencies received significant comment regarding the proposed market-making exemption. In this Part, the Agencies highlight the main issues, concerns, and suggestions raised by commenters with respect to the proposed market-making exemption. As discussed in greater detail below, commenters’ views on the effectiveness of the proposed exemption varied. Commenters discussed a broad range of topics related to the proposed marketmaking exemption including, among others: The overall scope of the proposed exemption and potential restrictions on market making in certain markets or asset classes; the potential market impact of the proposed marketmaking exemption; the appropriate level of analysis for compliance with the proposed exemption; the effectiveness of the individual requirements of the proposed exemption; and specific activities that should or should not be considered permitted market makingrelated activity under the rule. a. Comments on the Overall Scope of the Proposed Exemption With respect to the general scope of the exemption, a number of commenters expressed concern that the proposed approach to implementing the marketmaking exemption is too narrow or restrictive, particularly with respect to less liquid markets. These commenters expressed concern that the proposed exemption would not be workable in many markets and asset classes and does not take into account how marketmaking services are provided in those markets and asset classes.503 Some commenters expressed particular concern that the proposed exemption may restrict or limit certain activities currently conducted by market makers (e.g., holding inventory or interdealer trading).504 Several commenters stated

e.g., AFR et al. (Feb. 2012); Public Citizen; Johnson & Prof. Stiglitz. Other commenters expressed concern that the proposed rule could limit interdealer trading. See, e.g., Prof. Duffie; Credit Suisse (Seidel); JPMC; Morgan Stanley; Goldman (Prop. Trading); Chamber (Feb. 2012); Oliver Wyman (Dec. 2011). 505See, e.g., BlackRock; Putnam; Fixed Income Forum/Credit Roundtable; ACLI (Feb. 2012); MetLife; IAA; Wells Fargo (Prop. Trading); T. Rowe Price; Sen. Bennet; Sen. Corker; PUC Texas; Fidelity; ICI (Feb. 2012); Invesco. 506See, e.g., Wellington; Prof. Duffie; Standish Mellon; Commissioner Barnier; NYSE Euronext; BoA; Citigroup (Feb. 2012); STANY; ICE; Chamber (Feb. 2012); BDA (Feb. 2012); Putnam; FTN; Fixed Income Forum/Credit Roundtable; ACLI (Feb. 2012); IAA; CME Group; Capital Group; PUC Texas; Columbia Mgmt.; SSgA (Feb. 2012); Eaton Vance; ICI (Feb. 2012); Invesco; Comm. on Capital Markets Regulation; Oliver Wyman (Feb. 2012); SIFMA (Asset Mgmt.) (Feb. 2012); Thakor Study. 507For example, some commenters stated that market makers may revert to an agency or ‘‘special order’’ model. See, e.g., Barclays; Goldman (Prop. Trading); ACLI (Feb. 2012); Vanguard; RBC. In addition, some commenters stated that new systems will be developed, such as alternative market matching networks, but these commenters disagreed about whether such changes would happen in the near term. See, e.g., CalPERS; BlackRock; Stuyvesant; Comm. on Capital Markets Regulation. Other commenters stated that it is unlikely that new systems will be developed. See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Oliver Wyman (Feb. 2012). One commenter stated that the proposed rule may cause a banking organization that engages in significant market-making activity to give up its banking charter or spin off its marketmaking operations to avoid compliance with the proposed exemption. See Prof. Duffie. 508See, e.g., NASP; Wellington; JPMC; Morgan Stanley; Credit Suisse (Seidel); BoA; Goldman (Prop. Trading); Citigroup (Feb. 2012); STANY; SIFMA (Asset Mgmt.) (Feb. 2012); Chamber (Feb. 2012); Putnam; ICI (Feb. 2012); Wells Fargo (Prop. Trading); NYSE Euronext; Sen. Corker; Invesco. 509See, e.g., Better Markets (Feb. 2012); Sens. Merkley & Levin (Feb. 2012); Occupy; AFR et al. (Feb. 2012); Public Citizen; Johnson & Prof. Stiglitz. 510See, e.g., Johnson & Prof. Stiglitz; Sens. Merkley & Levin (Feb. 2012); Occupy; AFR et al. (Feb. 2012); Public Citizen. 511See Occupy (‘‘[I]t is unclear that this rule, as written, will markedly alter the current customerserving business. Indeed, this rule has gone to excessive lengths to protect the covered banking entities’ ability to maintain responsible customerfacing business.’’); Alfred Brock. 512See, e.g., Rep. Bachus et al.; IIF; Morgan Stanley (stating that beyond walled-off proprietary trading, the line is hard to draw, particularly because both require principal risk-taking and the features of market making vary across markets and asset classes and
become more pronounced in times of market stress); CFA Inst. (representing that the distinction is particularly difficult in the fixedincome market); ICFR; Prof. Duffie; WR Hambrecht. 513See, e.g., Chamber (Feb. 2012) (citing an article by Stephen Breyer stating that society should not expend disproportionate resources trying to reduce or eliminate ‘‘the last 10 percent’’ of the risks of a certain problem); JPMC; RBC; ICFR; Sen. Hagan. One of these commenters indicated that any concerns that banking entities would engage in speculative trading as a result of an expansive market-making exemption would be addressed by other reform initiatives (e.g., Basel III implementation will provide laddered disincentives to holding positions as principal as a result of capital and liquidity requirements). See RBC. 514See Wellington; Paul Volcker; Better Markets (Feb. 2012); Occupy. 515See Wellington. 516See Paul Volcker. 517See Wellington; SIFMA et al. (Prop. Trading) (Feb. 2012); Barclays; Goldman (Prop. Trading); HSBC; Fixed Income Forum/Credit Roundtable; ACLI (Feb. 2012); PUC Texas; ERCOT; Invesco. See also IAA (stating that it is unclear whether the requirements must be applied on a transaction-bytransaction basis or if compliance with the requirements is based on overall activities). This issue is addressed in Part IV.A.3.c.1.c., infra. 518See, e.g., Barclays; SIFMA et al. (Prop. Trading) (Feb. 2012). As explained above, the term ‘‘covered financial position’’ from the proposal has been replaced by the term ‘‘financial instrument’’ in the final rule. Because the types of instruments included in both definitions are identical, the term ‘‘financial instrument’’ is used throughout this Part. 519See, e.g., Goldman (Prop. Trading); Wellington. 520See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Barclays (stating that ‘‘hundreds or thousands of trades can occur in a single day in a single trading unit’’). 521See, e.g., ICI (Feb. 2012); Barclays; Goldman (Prop. Trading). 522See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading). that the proposed exemption would create too much uncertainty regarding compliance 505 and, further, may have a chilling effect on banking entities’ market making-related activities.506 Due to the perceived restrictions and burdens of the proposed exemption, many commenters indicated that the rule may change the way in which market-making services are provided.507 A number of commenters expressed the view that the proposed exemption is inconsistent with Congressional intent because it would restrict and reduce banking entities’ current market makingrelated activities.508 Other commenters, however, stated that the proposed exemption was too broad and recommended that the rule place greater restrictions on market making, particularly in illiquid, nontransparent markets.509 Many of these commenters suggested that the exemption should only be available for traditional market-making activity in relatively safe,
‘‘plain vanilla’’ instruments.510 Two commenters represented that the proposed exemption would have little to no impact on banking entities’ current market making-related services.511 Commenters expressed differing views regarding the ease or difficulty of distinguishing permitted market making-related activity from prohibited proprietary trading. A number of commenters represented that it is difficult or impossible to distinguish prohibited proprietary trading from permitted market making-related activity.512 With regard to this issue, several commenters recommended that the Agencies not try to remove all aspects of proprietary trading from market making-related activity because doing so would likely restrict certain legitimate market-making activity.513 Other commenters were of the view that it is possible to differentiate between prohibited proprietary trading and permitted market making-related activity.514 For example, one commenter stated that, while the analysis may involve subtle distinctions, the fundamental difference between a banking entity’s market-making activities and proprietary trading activities is the emphasis in market making on seeking to meet customer needs on a consistent and reliable basis throughout a market cycle.515 According to another commenter, holding substantial securities in a trading book for an extended period of time assumes the character of a proprietary position and, while there may be occasions when a customer-oriented purchase and subsequent sale extend over days and cannot be more quickly executed or hedged, substantial holdings of this character should be relatively rare and limited to less liquid markets.516 Several commenters expressed general concern that the proposed exemption may be applied on a transaction-by-transaction basis and explained the burdens that may result from such an approach.517 Commenters appeared to attribute these concerns to language in the proposed exemption referring to a ‘‘purchase or sale of a [financial instrument]’’ 518 or to language in Appendix B indicating that the Agencies may assess certain factors and criteria at different levels, including a ‘‘single significant transaction.’’ 519 With respect to the burdens of a transaction-by-transaction analysis, some commenters noted that banking entities can engage in a large volume of market-making transactions daily, which would make it burdensome to apply the exemption to each trade.520 A few commenters indicated that, even if the Agencies did not intend to require transaction-by-transaction analysis, the proposed rule’s language can be read to imply such a requirement. These commenters indicated that ambiguity on this issue could have a chilling effect on market making or could allow some examiners to rigidly apply the requirements of the exemption on a trade-by-trade basis.521 Other commenters indicated that it would be difficult to determine whether a particular trade was or was not a market-making trade without
consideration of the relevant unit’s overall activities.522 One commenter elaborated on this point by stating that

523SIFMA et al. (Prop. Trading) (Feb. 2012). 524See id. (suggesting that the Agencies ‘‘give full effect to the statutory intent to allow market making by viewing the permitted activity on a holistic basis’’). 525See ACLI (Feb. 2012); Fixed Income Forum/ Credit Roundtable. 526See Wellington; Morgan Stanley; SIFMA et al. (Prop. Trading) (Feb. 2012); ACLI (Feb. 2012); Fixed Income Forum/Credit Roundtable. The Agencies address this topic in Part IV.A.3.c.1.c., infra. 527See Wellington. This commenter did not provide greater specificity about how it would define ‘‘trading desk’’ or ‘‘aggregation unit.’’ See id. 528See Morgan Stanley (stating that ‘‘trading unit’’ should be defined as ‘‘each organizational unit that is used to structure and control the aggregate risk-taking activities and employees that are engaged in the coordinated implementation of a customer-facing revenue generation strategy and that participate in the execution of any covered trading activity’’); SIFMA et al. (Prop. Trading) (Feb. 2012). One of these commenters discussed its suggested definition of ‘‘trading unit’’ in the context of the proposed requirement to record and report certain quantitative measurements, but it is unclear that the commenter was also suggesting that this definition be used for purposes of the marketmaking exemption. For example, this commenter expressed support for a multi-level approach to defining ‘‘trading unit,’’ and it is not clear how a definition that captures multiple organizational levels across a banking organization would work in the context of the market-making exemption. See SIFMA et al. (Prop. Trading) (Feb. 2012) (suggested that ‘‘trading unit’’ be defined ‘‘at a level that presents its activities in the context of the whole’’ and noting that the appropriate level may differ depending on the structure of the banking entity). 529See, e.g., Wellington; Japanese Bankers Ass’n.; Prof. Duffie; IR&M; G2 FinTech; MetLife; NYSE Euronext; Anthony Flynn and Koral Fusselman; IIF; CalPERS; SIFMA et al. (Prop. Trading) (Feb. 2012); Sens. Merkley & Levin (Feb. 2012); Shadow Fin. Regulatory Comm.; John Reed; Prof. Richardson; Credit Suisse (Seidel); JPMC; Morgan Stanley; Barclays; Goldman (Prop. Trading); BoA; Citigroup (Feb. 2012); STANY; ICE; BlackRock; Johnson & Prof. Stiglitz; Fixed Income Forum/Credit Roundtable; ACLI (Feb. 2012); Wells Fargo (Prop. Trading); WR Hambrecht; Vanguard; Capital Group; PUC Texas; SSgA (Feb. 2012); PNC et al.; Fidelity; Occupy; AFR et al. (Feb. 2012); Invesco; ISDA (Feb. 2012); Stephen Roach; Oliver Wyman (Feb. 2012). The Agencies respond to these comments in Part IV.A.3.b.3., infra. 530See, e.g., Sens. Merkley & Levin (Feb. 2012); John Reed; Prof. Richardson; Johnson & Prof. Stiglitz; Capital Group; Invesco; BDA (Feb. 2012) (Oct. 2012) (suggesting a safe harbor for any trading desk that effects more than 50 percent of its transactions through sales representatives). 531See, e.g., Flynn & Fusselman; Prof. Colesanti et al.
532See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); IIF; NYSE Euronext; Credit Suisse (Seidel); JPMC; Barclays; BoA; Wells Fargo (Prop. Trading) (suggesting that the rule: (i) Provide a general grant of authority to engage in any transactions entered into as part of a banking entity’s market-making business, where ‘‘market making’’ is defined as ‘‘the business of being willing to facilitate customer purchases and sales of [financial instruments] as an intermediary over time and in size, including by holding positions in inventory;’’ and (ii) allow banking entities to monitor compliance with this exemption internally through their compliance and risk management infrastructure); PNC et al.; Oliver Wyman (Feb. 2012). 533See, e.g., Goldman (Prop. Trading); Morgan Stanley; Barclays; Wellington; CalPERS; BlackRock; SSgA (Feb. 2012); Invesco. 534See, e.g., SIFMA et al. (Prop. Trading) (Feb.
2012) (suggesting that this guidance could be
incorporated in banking entities’ policies and procedures for purposes of complying with the rule, in addition to the establishment of risk limits, controls, and metrics); JPMC; BoA; PUC Texas; SSgA (Feb. 2012); PNC et al.; Wells Fargo (Prop. Trading). 535See, e.g., Japanese Bankers Ass’n.; Citigroup (Feb. 2012). 536See, e.g., Morgan Stanley; Stephen Roach. 537See, e.g., Prof. Duffie; CalPERS; STANY; ICE; Vanguard; Capital Group. 538See MetLife; Fixed Income Forum/Credit Roundtable; ACLI (Feb. 2012). 539See, e.g., Prof. Duffie; Shadow Fin. Regulatory Comm. See also Wedbush. 540See WR Hambrecht. 541See G2 FinTech. 542See ISDA (Feb. 2012); ISDA (Apr. 2012). 543See Sens. Merkley & Levin (Feb. 2012) (stating that the exemption should expressly mention the conflicts provision and provide examples to warn against particular conflicts, such as recommending clients buy poorly performing assets in order to remove them from the banking entity’s book or attempting to move market prices in favor of trading positions a banking entity has built up in order to make a profit); Stephen Roach (suggesting that the exemption integrate the limitations on permitted activities). 544See Fidelity (stating that the exemption needs to be as broad as possible to account for customerfacing principal trades, block trades, and market making in OTC derivatives). See also STANY (stating that it is better to make the exemption too broad than too narrow). 545See, e.g., AllianceBernstein; Rep. Bachus et al. (Dec. 2011); EMTA; NASP; Wellington; Japanese Bankers Ass’n.; Sen. Hagan; Prof. Duffie; Investure; Standish Mellon; IR&M; MetLife; Lord Abbett; Commissioner Barnier; Quebec; IIF; Sumitomo Trust; Liberty Global; NYSE Euronext; CIEBA; EFAMA; SIFMA et al. (Prop. Trading) (Feb. 2012); Credit Suisse (Seidel); JPMC; Morgan Stanley; Barclays; Goldman (Prop. Trading); BoA; Citigroup (Feb. 2012); STANY; ICE; BlackRock; SIFMA (Asset Mgmt.) (Feb. 2012); BDA (Feb. 2012); Putnam; Fixed Income Forum/Credit Roundtable; Western Asset Mgmt.; ACLI (Feb. 2012); IAA; CME Group; Wells Fargo (Prop. Trading); Abbott Labs et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012); T. Rowe Price; Australian Bankers Ass’n. (Feb. 2012); FEI; AFMA; Sen. Carper et al.; PUC Texas; ERCOT; IHS; Columbia Mgmt.; SSgA (Feb. 2012); PNC et al.; Eaton Vance; Fidelity; ICI (Feb. 2012); British Bankers’ Ass’n.; Comm. on Capital Markets Regulation; Union Asset; Sen. Casey; Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012) (providing estimated impacts on asset valuation, borrowing costs, and transaction costs in the corporate bond market based on hypothetical liquidity reduction ‘‘an analysis that seeks to characterize specific transactions as either market making. . . or prohibited activity does not accord with the way in which modern trading units operate, which generally view individual positions as a bundle of characteristics that contribute to their complete portfolio.’’ 523 This commenter noted that a position
entered into as part of market making-related activities may serve multiple functions at one time, such as responding to customer demand, hedging a risk, and building inventory. The commenter also expressed concern that individual transactions or positions may not be severable or separately identifiable as serving a market-making purpose.524 Two commenters suggested that the requirements in the market-making exemption be applied at the portfolio level rather than the trade level.525 Moreover, commenters also set forth their views on the organizational level at which the requirements of the proposed market-making exemption should apply.526 The proposed exemption generally applied requirements to a ‘‘trading desk or other organizational unit’’ of a banking entity. In response to this proposed approach, commenters stated that compliance should be assessed at each trading desk or aggregation unit 527 or at each trading unit.528 Several commenters suggested alternative or additive means of implementing the statutory exemption for market making-related activity.529 Commenters’ recommended approaches varied, but a number of commenters requested approaches involving one or more of the following elements: (i) Safe harbors,530 bright lines,531 or presumptions of compliance with the exemption based on the existence of certain factors (e.g., compliance program, metrics, general customer focus or orientation, providing liquidity, and/or exchange registration as a market maker); 532 (ii) a focus on metrics or other objective factors; 533 (iii) guidance on permitted market making-related activity, rather than rule requirements; 534 (iv) risk management structures and/or risk limits; 535 (v) adding a new customer-facing criterion or focusing on client-related activities; 536 (vi) capital and liquidity requirements; 537 (vii) development of individualized plans for each banking entity, in coordination with regulators; 538 (viii) ring fencing affiliates engaged in market makingrelated activity; 539 (ix) margin requirements; 540 (x) a compensationfocused approach; 541 (xi) permitting all swap dealing activity; 542 (xii) additional provisions regarding material conflicts of interest and high-risk assets and trading strategies; 543 and/or (xiii) making the exemption as broad as possible under the statute.544 b. Comments Regarding the Potential Market Impact of the Proposed Exemption As discussed above, several commenters stated that the proposed rule would impact a banking entity’s ability to engage in market makingrelated activity. Many of these commenters represented that, as a result, the proposed exemption would likely result in reduced liquidity,545

scenarios); Thakor Study. The Agencies respond to comments regarding the potential market impact of the rule in Part IV.A.3.b.3., infra. 546See, e.g., AllianceBernstein; Wellington; Investure; Standish Mellon; MetLife; Lord Abbett; Barclays; Goldman (Prop. Trading); Citigroup (Feb. 2012); BlackRock; Putnam; ACLI (Feb. 2012); Abbott Labs et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012); T. Rowe Price; Sen. Carper et al.; IHS; Columbia Mgmt.; ICI (Feb. 2012) British Bankers’ Ass’n.; Comm. on Capital Markets Regulation; Thakor Study (stating that section 13 of the BHC Act will likely result in higher bid-ask spreads by causing at least some retrenchment of banks from market making, resulting in fewer market makers and less competition). 547See, e.g., Wellington; Prof. Duffie; Standish Mellon; Lord Abbett; IIF; SIFMA et al. (Prop. Trading) (Feb. 2012); Barclays; Goldman (Prop. Trading); BDA (Feb. 2012); IHS; FTN; IAA; Wells Fargo (Prop. Trading); T. Rowe Price; Columbia Mgmt.; SSgA (Feb. 2012); Eaton Vance; British Bankers’ Ass’n.; Comm. on Capital Markets Regulation. 548See, e.g., Prof. Duffie (arguing that, for example, ‘‘during the financial crisis of 2007–2009, the reduced market making capacity of major dealer banks caused by their insufficient capital levels resulted in dramatic downward distortions in corporate bond prices’’); IIF; Barclays; IAA; Vanguard; Wellington; FTN. 549See, e.g., AllianceBernstein; Chamber (Dec. 2011); Members of Congress (Dec. 2011); Wellington; Sen. Hagan; Prof. Duffie; IR&M; MetLife; Lord Abbett; Liberty Global; NYSE Euronext; SIFMA et al. (Prop. Trading) (Feb. 2012); NCSHA; ASF (Feb. 2012) (stating that ‘‘[f]ailure to permit the activities necessary for banking entities to act in [a] market-making capacity [in assetbacked securities] would have a dramatic adverse effect on the ability of securitizers to access the asset-backed securities markets and thus to obtain the debt financing necessary to ensure a vibrant U.S. economy’’); Credit Suisse (Seidel); JPMC; Morgan Stanley; Barclays; Goldman (Prop. Trading); BoA; Citigroup (Feb. 2012); STANY; BlackRock; Chamber (Feb. 2012); IHS; BDA (Feb. 2012); Fixed Income Forum/Credit Roundtable; ACLI (Feb. 2012); Wells Fargo (Prop. Trading); Abbott Labs et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012); T. Rowe Price; FEI; AFMA; SSgA (Feb. 2012); PNC et al.; ICI (Feb. 2012); British Bankers’ Ass’n.; Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012); GE (Feb. 2012); Thakor Study (stating that when a firm’s cost of capital goes up, it invests less—resulting in lower economic growth and lower employment—and citing supporting data indicating that a 1 percent increase in the cost of capital would lead to a $55 to $82.5 billion decline in aggregate annual capital spending by U.S. nonfarm firms and job losses between 550,000 and 1.1 million per year in the nonfarm sector). One commenter further noted that a higher cost of capital can lead a firm to make riskier,
short-term investments. See Thakor Study. 550See, e.g., Wellington; Standish Mellon; IR&M; MetLife; Lord Abbett; NYSE Euronext; CIEBA; Barclays; Goldman (Prop. Trading); BoA; Citigroup (Feb. 2012); STANY; ICE; BlackRock; Fixed Income Forum/Credit Roundtable; ACLI (Feb. 2012); IAA; Abbott Labs et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012); T. Rowe Price; Vanguard; Australian Bankers Ass’n. (Feb. 2012); FEI; Sen. Carper et al.; Columbia Mgmt.; SSgA (Feb. 2012); ICI (Feb. 2012); Comm. on Capital Markets Regulation; TMA Hong Kong; Sen. Casey; IHS; Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012); Thakor Study. 551See, e.g., Barclays; FTN; Abbott Labs et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012). 552See, e.g., AllianceBernstein (stating that, to the extent the rule reduces liquidity provided by market makers, open end mutual funds that are largely driven by the need to respond to both redemptions and subscriptions will be immediately impacted in terms of higher trading costs); Wellington (indicating that periods of extreme market stress are likely to exacerbate costs and challenges, which could force investors such as mutual funds and pension funds to accept distressed prices to fund redemptions or pay current benefits); Lord Abbett (stating that certain factors, such as reduced bank capital to support market-making businesses and economic uncertainty, have already reduced liquidity and caused asset managers to have an increased preference for highly liquid credits and expressing concern that, if section 13 of the BHC Act further reduces liquidity, then: (i) Asset managers’ increased preference for highly liquid credit could lead to unhealthy portfolio concentrations, and (ii) asset managers will maintain a larger cash cushion in portfolios that may be subject to redemption, which will likely result in investors getting poorer returns); EFAMA; BlackRock (stating that investment decisions are heavily dependent on a liquidity factor input, so as liquidity dissipates, investment strategies become more limited and returns to investors are diminished by wider spreads and higher transaction costs); CFA Inst. (noting that a mutual fund that tries to liquidate holdings to meet redemptions may have difficulty selling at acceptable prices, thus impairing the fund’s NAV for both redeeming investors and for those that remain in the fund); Putnam; Fixed Income Forum/Credit Roundtable; ACLI; T. Rowe Price; Vanguard; IAA; FEI; Sen. Carper et al.; Columbia Mgmt.; ICI (Feb. 2012); Invesco; Union Asset; Standish Mellon; Morgan Stanley; SIFMA (Asset Mgmt.) (Feb. 2012). 553See, e.g., CIEBA (stating that for smaller issuers in particular, market makers need to have incentives to make markets, and the proposal removes important incentives); ACLI (indicating that lower liquidity will most likely result in higher costs for issuers of debt and, for lesser known or lower quality issuers, this cost may be significant and in some cases prohibitive
because the cost will vary depending on the credit quality of the issuer, the amount of debt it has in the market, and the maturity of the security); PNC et al. (expressing concern that a regional bank’s market-making activity for small and middle market customers is more likely to be inappropriately characterized as impermissible proprietary trading due to lower trading volume involving less liquid securities); Morgan Stanley; Chamber (Feb. 2012); Abbott Labs et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012); FEI; ICI (Feb. 2012); TMA Hong Kong; Sen. Casey. 554See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; RBC; NYSE Euronext; Credit Suisse (Seidel). 555See, e.g., Paul Volcker; AFR et al. (Feb. 2012); Public Citizen; Prof. Richardson; Johnson & Prof. Stiglitz; Better Markets (Feb. 2012); Prof. Johnson. 556See AFR et al. (Feb. 2012); Public Citizen. See also Paul Volcker (stating that at some point, greater liquidity, or the perception of greater liquidity, may encourage more speculative trading). 557See Prof. Richardson. 558See, e.g., Johnson & Prof. Stiglitz (citing Thomas Phillippon, Has the U.S. Finance Industry Become Less Efficient?, NYU Working Paper, Nov. 2011); AFR et al. (Feb. 2012); Public Citizen; Better Markets (Feb. 2012); Prof. Johnson. 559See, e.g., Sens. Merkley & Levin (Feb. 2012) (stating that there is no convincing, independent evidence that the rule would increase trading costs or reduce liquidity, and the best evidence available suggests that the buy-side firms would greatly benefit from the competitive pressures that transparency can bring); Better Markets (Feb. 2012) (‘‘Industry’s claim that [section 13 of the BHC Act] will ‘reduce market liquidity, capital formation, and credit availability, and thereby hamper economic growth and job creation’ disregard the fact that the financial crisis did more damage to those concerns than any rule or reform possibly could.’’); Profs. Stout & Hastings; Prof. Johnson; Occupy; Public Citizen; Profs. Admati & Pfleiderer; Better Markets (June 2012); AFR et al. (Feb. 2012). One commenter stated that the proposed rule would improve market liquidity, efficiency, and price transparency. See Alfred Brock. wider bid-ask spreads,546 increased market volatility,547 reduced price discovery or price transparency,548 increased costs of raising capital or higher financing costs,549 greater costs for investors or consumers,550 and slower execution times.551 Some commenters expressed particular concern about potential impacts on institutional investors (e.g., mutual funds and pension funds) 552 or on small or midsized companies.553 A number of commenters discussed the interrelationship between primary and secondary market activity and indicated that restrictions on market making would impact the underwriting process.554 A few commenters expressed the view that reduced liquidity would not necessarily be a negative result.555 For example, two commenters noted that liquidity is vulnerable to
liquidity spirals, in which a high level of market liquidity during one period feeds a sharp decline in liquidity during the next period by initially driving asset prices upward and supporting increased leverage. The commenters explained that liquidity spirals lead to ‘‘fire sales’’ by market speculators when events reveal that assets are overpriced and speculators must sell their assets to reduce their leverage.556 According to another commenter, banking entities’ access to the safety net allows them to distort market prices and, arguably, produce excess liquidity. The commenter further represented that it would be preferable to allow the discipline of the market to choose the pricing of securities and the amount of liquidity.557 Some commenters cited an economic study indicating that the U.S. financial system has become less efficient in generating economic growth in recent years, despite increased trading volumes.558 Some commenters stated that it is unlikely the proposed rule would result in the negative market impacts identified above, such as reduced market liquidity.559 For example, a few commenters stated that other market participants, who are not subject to
section 13 of the BHC Act, may enter the
market or increase their trading activities to make up for any reduction in banking entities’ market-making

560See, e.g., Sens. Merkley & Levin (Feb. 2012); Prof. Richardson; Better Markets (Feb. 2012); Profs. Stout & Hastings; Prof. Johnson; Occupy; Public Citizen; Profs. Admati & Pfleiderer; Better Markets (June 2012). Similarly, one commenter indicated that non-banking entity market participants could fill the current role of banking entities in the market if implementation of the rule is phased in. See ACLI (Feb. 2012). 561See Better Markets (Feb. 2012). 562See Prof. Johnson. 563See AFR et al. (Feb. 2012). 564See, e.g., Wellington; Prof. Duffie; Investure; IIF; Liberty Global; SIFMA et al. (Prop. Trading) (Feb. 2012); Credit Suisse (Seidel); JPMC; Morgan Stanley; Barclays; BoA; STANY; SIFMA (Asset Mgmt.) (Feb. 2012); FTN; Western Asset Mgmt.; IAA; PUC Texas; ICI (Feb. 2012); IIB/EBF; Invesco. In addition, some commenters recognized that other market participants are likely to fill banking entities’ roles in the long term, but not in the short term. See, e.g., ICFR; Comm. on Capital Markets Regulation; Oliver Wyman (Feb. 2012). 565See Oliver Wyman (Feb. 2012) (‘‘Major bankaffiliated market makers have large capital bases, balance sheets, technology platforms, global operations, relationships with clients, sales forces, risk infrastructure, and management processes that would take smaller or new dealers years and billions of dollars to replicate.’’). 566See SIFMA et al. (Prop. Trading) (Feb. 2012). 567See Thakor Study. 568See, e.g., Prof. Duffie; Oliver Wyman (Feb. 2012). 569See, e.g., MetLife; SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; Credit Suisse (Seidel); JPMC; BoA; ACLI (Feb. 2012); AFR et al. (Feb. 2012); ISDA (Feb. 2012); Goldman (Prop. Trading); Oliver Wyman (Feb. 2012). 570See SIFMA et al. (Prop. Trading) (Feb. 2012); Chamber (Feb. 2012); Goldman (Prop. Trading). 571See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Credit Suisse (Seidel); Goldman (Prop. Trading); MFA; RBC. 572See infra Part IV.A.3.c.1.b.ii. (discussing commenters’ requests for greater clarity regarding the permissibility of block positioning activity). 573See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); BoA; ICI (Feb. 2012); ICI Global; Vanguard; SSgA (Feb. 2012). 574See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); FTN; RBC; ISDA (Feb. 2012). 575See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; Goldman (Prop. Trading); Banco de Me´xico; IIB/EBF. 576See CME Group (requesting clarification that the market-making exemption permits a banking entity to engage in market making in exchangetraded futures and options because the dealer registration requirement in §ll.4(b)(2)(iv) of the proposed rule did not refer to such instruments and stating that lack of an explicit exemption would reduce market-making activities in these instruments, which would decrease liquidity). But See Johnson & Prof. Stiglitz (stating that the Agencies should pay special
attention to options trading and other derivatives because they are highly volatile assets that are difficult if not impossible to effectively hedge, except through a completely matched position, and suggesting that options and similar derivatives may need to be required to be sold only as riskless principal under §ll.6(b)(1)(ii) of the proposed rule or significantly limited through capital charges); Sens. Merkley & Levin (Feb. 2012) (stating that asset classes that are particularly hard to hedge, such as options, should be given special attention under the hedging exemption). 577See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); SIFMA (Asset Mgmt.) (Feb. 2012). Other commenters, however, stated that banking entities should be limited in their ability to rely on the market-making exemption to conduct transactions in bespoke or customized derivatives. See, e.g., AFR et al. (Feb. 2012); Public Citizen. 578See, e.g., Japanese Bankers Ass’n. (stating that transactions with affiliates and subsidiaries and related to hedging activities are a type of market making-related activity or risk-mitigating hedging activity that should be exempted by the rule); SIFMA et al. (Prop. Trading) (Feb. 2012). According to one of these commenters, inter-affiliate transactions should be viewed as part of a coordinated activity for purposes of determining whether a banking entity qualifies for an exemption. This commenter stated that, for example, if a market maker shifts positions held in inventory to an affiliate that is better able to manage the risk of such positions, both the market maker and its affiliate would be engaged in permitted market making-related activity. This commenter further represented that fitting the inter-affiliate swap into the exemption may be difficult (e.g., one of the affiliates entering into the swap may not be holding itself out as a willing counterparty). See SIFMA et al. (Prop. Trading) (Feb. 2012). 579See, e.g., Cleary Gottlieb; JPMC; BoA; Credit Suisse (Williams). 580See, e.g., Occupy; Alfred Brock. 581See, e.g., Occupy; AFR et al. (Feb. 2012); Public Citizen; Johnson & Prof. Stiglitz; Sens. Merkley & Levin (Feb. 2012); John Reed. activity or other trading activity.560 For instance, one of these commenters suggested that the revenue and profits from market making will be sufficient to attract capital and competition to that activity.561 In addition, one commenter expressed the view that prohibiting proprietary trading may support more liquid markets by ensuring that banking entities focus on providing liquidity as market makers, rather than taking liquidity from the market in the course of ‘‘trading to beat’’ institutional buyers like pension funds, university endowments, and mutual funds.562 Another commenter stated that, while
section 13 of the BHC Act may
temporarily reduce trading volume and excessive liquidity at the peak of market bubbles, it should increase the long-run stability of the financial system and render genuine liquidity and credit availability more reliable over the long term.563 Other commenters, however, indicated that it is uncertain or unlikely that non-banking entities will enter the market or increase their trading activities, particularly in the short term.564 For example, one commenter noted the investment that banking entities have made in infrastructure for trading and compliance would take smaller or new firms years and billions of dollars to replicate.565 Another commenter questioned whether other market participants, such as hedge funds, would be willing to dedicate capital to fully serving customer needs, which is required to provide ongoing liquidity.566 One commenter stated that even if non-banking entities move in to replace lost trading activity from banking entities, the value of the current interdealer network among market makers will be reduced due to the exit of banking entities.567 Several commenters expressed the view that migration of market making-related activities to firms outside the banking system would be inconsistent with Congressional intent and would have potentially adverse consequences for the safety and soundness of the U.S. financial system.568 Many commenters requested additional clarification on how the proposed market-making exemption would apply to certain asset classes and markets or to particular types of market making-related activities. In particular, commenters requested greater clarity regarding the permissibility of: (i) interdealer trading,569 including trading for price discovery purposes or to test market depth; 570 (ii) inventory management; 571 (iii) block positioning activity; 572 (iv) acting as an authorized participant or market maker in ETFs; 573 (v) arbitrage or other activities that promote price transparency and liquidity; 574 (vi) primary dealer activity; 575 (vii) market making in futures and options; 576 (viii) market making in new or bespoke products or customized hedging contracts; 577 and (ix) inter-affiliate transactions.578 As discussed in more detail in Part IV.B.2.c., a number of commenters requested that the market-making exemption apply to the restrictions on acquiring or retaining an ownership interest in a covered fund.579 Some commenters stated that no other activities should be considered permitted market making-related activity under the rule.580 In addition, a few commenters requested clarification that high-frequency trading would not qualify for the market-making exemption.581
3. Final Market-Making Exemption
After carefully considering comment letters, the Agencies are adopting certain refinements to the proposed market-making exemption. The Agencies are adopting a market-making exemption that is consistent with the statutory exemption for this activity and designed to permit banking entities to continue providing intermediation and liquidity services. The Agencies note that, while all market-making activity should ultimately be related to the intermediation of trading, whether directly to individual customers through bilateral transactions or more broadly to

582Consistent with the FSOC study and the proposal, the final rule recognizes that the precise nature of a market maker’s activities often varies depending on the liquidity, trade size, market infrastructure, trading volumes and frequency, and geographic location of the market for any particular type of financial instrument. See Joint Proposal, 76 FR 68,870; CFTC Proposal, 77 FR 8356; FSOC study (stating that ‘‘characteristics of permitted activities in one market or asset class may not be the same in another market (e.g., permitted activities in a liquid equity securities market may vary significantly from an illiquid over-the-counter derivatives market)’’). 583Certain of these requirements, like the requirements to have risk and inventory limits, risk management strategies, and monitoring and review requirements were included in the enhanced compliance program requirement in proposed
Appendix C, but were not separately included in
the proposed market-making exemption. Like the statute, the proposed rule would have required that market making-related activities be designed not to exceed the reasonably expected near term demand of clients, customers, or counterparties. The Agencies are adding an explicit requirement in the final rule that a trading desk conduct analyses of customer demand for purposes of complying with this statutory requirement. 584See infra Part IV.A.3.c.1.c.ii. See also final rule §§ll.4(b)(4), (5). 585See infra Part IV.A.3.c.1.c.i. The term ‘‘trading desk’’ is defined as ‘‘the smallest discrete unit of organization of a banking entity that buys or sells financial instruments for the trading account of the banking entity or an affiliate thereof.’’ Final rule §ll.3(e)(13). 586See final rule §ll.4(b)(2)(i); infra Part IV.A.3.c.1.c.iii. 587See final rule §ll.4(b)(2)(ii); infra Part IV.A.3.c.2.c. In addition, the Agencies are adopting a definition of the terms ‘‘client,’’ ‘‘customer,’’ and ‘‘counterparty’’ in §ll.4(b)(3) of the final rule. 588Routine market making-related risk management activity by a trading desk is permitted under the market-making exemption and, provided the standards of the exemption are met, is not required to separately meet the requirements of the hedging exemption. The circumstances under which risk management activity relating to the trading desk’s financial exposure is permitted under the market-making exemption or must separately comply with the hedging exemption are discussed in more detail in Parts IV.A.3.c.1.c.ii. and IV.A.3.c.4., infra. a given marketplace, certain characteristics of a market-making business may differ among markets and asset classes.582 The final rule is intended to account for these differences to allow banking entities to continue to engage in market makingrelated activities by providing customer intermediation and liquidity services across markets and asset classes, if such activities do not violate the statutory limitations on permitted activities (e.g., by involving or resulting in a material conflict of interest with a client, customer, or counterparty) and are conducted in conformance with the exemption. At the same time, the final rule requires development and implementation of trading, risk and inventory limits, risk management strategies, analyses of how the specific market making-related activities are designed not to exceed the reasonably expected near term demands of customers, compensation standards, and monitoring and review requirements that are consistent with market-making activities.583 These requirements are designed to distinguish exempt market making-related activities from impermissible proprietary trading. In addition, these requirements are designed to ensure that a banking entity is aware of, monitors, and limits the risks of its exempt activities consistent with the prudent conduct of market making-related activities. As described in detail below, the final market-making exemption
consists of the following elements:

A framework that recognizes the
differences in market making-related activities across markets and asset classes by establishing criteria that can be applied based on the liquidity, maturity, and depth of the market for the particular type of financial instrument.
A general focus on analyzing the
overall ‘‘financial exposure’’ and ‘‘market-maker inventory’’ held by any given trading desk rather than a transaction-by-transaction analysis. The ‘‘financial exposure’’ reflects the aggregate risks of the financial instruments, and any associated loans, commodities, or foreign exchange or currency, held by a banking entity or its affiliate and managed by a particular trading desk as part of its market making-related activities. The ‘‘marketmaker inventory’’ means all of the positions, in the financial instruments for which the trading desk stands ready to make a market that are managed by the trading desk, including the trading desk’s open positions or exposures arising from open transactions.584
A definition of the term ‘‘trading
desk’’ that focuses on the operational functionality of the desk rather than its legal status, and requirements that apply at the trading desk level of organization within a single banking entity or across two or more affiliates.585
Five requirements for determining
whether a banking entity is engaged in permitted market making-related activities. Many of these criteria have similarities to the factors included in the proposed rule, but with important modifications in response to comments. These standards require that:
Æ The trading desk that establishes and manages a financial exposure routinely stands ready to purchase and sell one or more types of financial instruments related to its financial exposure and is willing and available to quote, buy and sell, or otherwise enter into long and short positions in those types of financial instruments for its own account, in commercially reasonable amounts and throughout market cycles, on a basis appropriate for the liquidity, maturity, and depth of the market for the relevant types of financial instruments; 586 Æ The amount, types, and risks of the financial instruments in the trading desk’s market-maker inventory are designed not to exceed, on an ongoing basis, the reasonably expected near term demands of clients, customers, or counterparties, as required by the statute and based on certain factors and analysis; 587 Æ The banking entity has established and implements, maintains, and enforces an internal compliance program that is reasonably designed to ensure its compliance with the marketmaking exemption, including reasonably designed written policies and procedures, internal controls, analysis, and independent testing identifying and addressing:
D The financial instruments each trading desk stands ready to purchase and sell in accordance with § ll .4(b)(2)(i) of the final rule; D The actions the trading desk will take to demonstrably reduce or otherwise significantly mitigate promptly the risks of its financial exposure consistent with its established limits; the products, instruments, and exposures each trading desk may use for risk management purposes; the techniques and strategies each trading desk may use to manage the risks of its market making-related activities and inventory; and the process, strategies, and personnel responsible for ensuring that the actions taken by the trading desk to mitigate these risks are and continue to be effective; 588 D Limits for each trading desk, based on the nature and amount of the trading desk’s market making-related activities, including factors used to determine the reasonably expected near term demands of clients, customers, or counterparties, on: the amount, types, and risks of its market-maker inventory; the amount, types, and risks of the products, instruments, and exposures the trading desk uses for risk management purposes; the level of exposures to relevant risk factors arising from its financial exposure; and the period of time a financial instrument may be held; D Internal controls and ongoing monitoring and analysis of each trading desk’s compliance with its limits; and D Authorization procedures, including escalation procedures that

589See final rule §ll.4(b)(2)(iii); infra Part IV.A.3.c.3. 590See final rule §ll.4(b)(2)(iv). 591See final rule §ll.4(b)(2)(v); infra Part IV.A.3.c.5. 592See final rule §ll.4(b)(2)(vi); infra Part IV.A.3.c.6. As discussed further below, this provision pertains to legal registration or licensing requirements that may apply to an entity engaged in market making-related activities, depending on the facts and circumstances. This provision would not require a banking entity to comply with registration requirements that are not required by law, such as discretionary registration with a national securities exchange as a market maker on that exchange. 593See infra Part IV.C.3. 594See supra Part IV.A.3.b.2. 595Certain approaches suggested by commenters, such as relying solely on capital requirements, requiring ring fencing, permitting all swap dealing activity, or focusing solely on how traders are compensated do not appear to be consistent with the statutory language because they do not appear to limit market making-related activity to that which is designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties, as required by the statute. See Prof. Duffie; STANY; ICE; Shadow Fin. Regulatory Comm.; ISDA (Feb. 2012); ISDA (Apr. 2012); G2 FinTech. 596While an approach establishing a number of safe harbors that are each tailored to a specific asset class would address the need to recognize differences across asset classes, such an approach may also increase the complexity of the final rule. Further, commenters did not provide sufficient information to determine the appropriate parameters of a safe harbor-based approach. 597As noted above, a number of commenters suggested the Agencies adopt a bright-line rule, provide a safe harbor for certain types of activities, or establish a presumption of compliance based on certain factors. See, e.g., Sens. Merkley & Levin (Feb. 2012); John Reed; Prof. Richardson; Johnson & Prof. Stiglitz; Capital Group; Invesco; BDA (Oct. 2012); Flynn & Fusselman; Prof. Colesanti et al.; SIFMA et al. (Prop. Trading) (Feb. 2012); IIF; NYSE Euronext; Credit Suisse (Seidel); JPMC; Barclays; BoA; Wells Fargo (Prop. Trading); PNC et al.; Oliver Wyman (Feb. 2012). Many of these commenters expressed general concern that the proposed market-making exemption may create uncertainty for individual traders engaged in market makingrelated activity and suggested that their proposed approach would alleviate such concern. The Agencies believe that the enhanced focus on risk and inventory limits for each trading desk (which must be tied to the near term customer demand requirement) and the clarification that the final market-making exemption does not require a tradeby-trade analysis should address concerns about individual traders having to assess whether they are complying with the market-making exemption on a trade-by-trade basis. 598Several commenters suggested a guidancebased approach, rather than
requirements in the final rule. See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012) (suggesting that this guidance could then be incorporated in banking entities’ policies and procedures for purposes of complying with the rule, in addition to the establishment of risk limits, controls, and metrics); JPMC; BoA; PUC Texas; SSgA (Feb. 2012); PNC et al.; Wells Fargo (Prop. Trading). 599See, e.g., Goldman (Prop. Trading); Morgan Stanley; Barclays; Wellington; CalPERS; BlackRock; SSgA (Feb. 2012); Invesco. 600See infra Part IV.C.3. (discussing the final rule’s metrics requirement). See SIFMA et al. (Prop. Trading) (Feb. 2012); Wells Fargo (Prop. Trading); RBC; ICI (Feb. 2012); Occupy (stating that there are serious limits to the capabilities of the metrics and the potential for abuse and manipulation of the input data is significant); Alfred Brock. 601See infra Part IV.C.3. (discussing the final metrics requirement). 602See, e.g., Japanese Bankers Ass’n.; Citigroup (Feb. 2012). 603However, as discussed below, the Agencies believe risk limits can be a useful tool when they must account for the nature and amount of a particular trading desk’s market making-related activities, including the reasonably expected near term demands of clients, customers, or counterparties. require review and approval of any trade that would exceed a trading desk’s limit(s), demonstrable analysis that the basis for any temporary or permanent increase to a trading desk’s limit(s) is consistent with the requirements of the market-making exemption, and independent review of such demonstrable analysis and approval; 589 Æ To the extent that any limit identified above is exceeded, the trading desk takes action to bring the trading desk into compliance with the limits as promptly as possible after the limit is exceeded; 590 Æ The compensation arrangements of persons performing market makingrelated activities are designed not to reward or incentivize prohibited proprietary trading; 591 and Æ The banking entity is licensed or registered to engage in market makingrelated activities in accordance with applicable law.592

The use of quantitative
measurements to highlight activities that warrant further review for compliance with the exemption.593 As discussed further in Part IV.C.3., the Agencies have reduced some of the compliance burdens by adopting a more tailored subset of metrics than was proposed to better focus on those metrics that the Agencies believe are most germane to the evaluation of the activities that firms conduct under the market-making exemption. In refining the proposed approach to implementing the statute’s marketmaking exemption, the Agencies closely considered the various alternative approaches suggested by commenters.594 However, like the proposed approach, the final marketmaking exemption continues to adhere to the statutory mandate that provides for an exemption to the prohibition on proprietary trading for market makingrelated activities. Therefore, the final rule focuses on providing a framework for assessing whether trading activities are consistent with market making. The Agencies believe this approach is consistent with the statute 595 and strikes an appropriate balance between commenters’ desire for both clarity and flexibility. For example, while a brightline or safe harbor based approach would generally provide a high degree of certainty about whether an activity qualifies for the market-making exemption, it would also provide less flexibility to recognize the differences in market-making activities across markets and asset classes.596 In addition, any bright-line approach would be more likely to be subject to gaming and avoidance as new products and types of trading activities are developed than other approaches to implementing the market-making exemption.597 Although a purely guidance-based approach would provide greater flexibility, it would also provide less clarity, which could make it difficult for trading personnel, internal compliance personnel, and Agency supervisors and examiners to determine whether an activity complies with the rule and would lead to an increased risk of evasion of the statutory requirements.598 Some commenters suggested an approach to implementing the marketmaking exemption that would focus on metrics or other objective factors.599 As discussed below, a number of commenters expressed support for using the metrics as a tool to monitor trading activity and not to determine compliance with the rule.600 While the Agencies agree that quantitative measurements are useful for purposes of monitoring a trading desk’s activities and are requiring certain banking entities to calculate, record, and report quantitative measurements to the Agencies in the final rule, the Agencies do not believe that quantitative measurements should be used as a dispositive tool for determining compliance with the market-making exemption.601 In response to two commenters’ request that the final rule focus on a banking entity’s risk management structures or risk limits and not on attempting to define market-making activities,602 the Agencies do not
believe that management of risk, on its own, is sufficient to differentiate permitted market making-related activities from impermissible proprietary trading. For example, the existence of a risk management framework or risk limits, while important, would not ensure that a trading desk is acting as a market maker by engaging in customer-facing activity and providing intermediation and liquidity services.603 The Agencies also decline to take an approach to implementing the market-making exemption that would require the development of individualized plans for each banking entity in coordination with the Agencies, as suggested by a few

604See MetLife; Fixed Income Forum/Credit Roundtable; ACLI (Feb. 2012). 605The Agencies are not, however, adding certain additional requirements suggested by commenters, such as a new customer-facing criterion, margin requirements, or additional provisions regarding material conflicts of interest or high-risk assets or trading strategies. See, e.g., Morgan Stanley; Stephen Roach; WR Hambrecht; Sens. Merkley & Levin (Feb. 2012). The Agencies believe that the final rule includes sufficient requirements to ensure that a trading desk relying on the market-making exemption is engaged in customer-facing activity (for example, the final rule requires the trading desk to stand ready to buy and sell a type of financial instrument as market maker and that the trading desk’s market-maker inventory is designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties). The Agencies decline to include margin requirements in the final exemption because banking entities are currently subject to a number of different margin requirements, including those applicable to, among others: SEC-registered broker-dealers; CFTCregistered swap dealers; SEC-registered securitybased swap dealers: And foreign dealer entities. Further, the Agencies are not providing new requirements regarding material conflicts of interest and high-risk assets and trading strategies in the market-making exemption because the Agencies believe these issues are adequately addressed in §ll.7 of the final rule. The limitations in §ll .7 will apply to market making-related activities and all other exempted activities. 606See supra note 545 and accompanying text. The Agencies acknowledge that reduced liquidity can be costly. One commenter provided estimated impacts on asset valuation, borrowing costs, and transaction costs in the corporate bond market based on certain hypothetical scenarios of reduced market liquidity. This commenter noted that its hypothetical liquidity shifts of 5, 10, and 15 percentile points were ‘‘necessarily arbitrary’’ but judged ‘‘to be realistic potential outcomes of the proposed rule.’’ Oliver Wyman (Feb. 2012). Because the Agencies have made significant modifications to the proposed rule in response to comments, the Agencies believe this commenter’s concerns about the market impacts of the proposed rule have been substantially addressed. 607As noted above, a few commenters stated that reduced liquidity may provide certain benefits. See, e.g., Paul Volcker; AFR et al. (Feb. 2012); Public Citizen; Prof. Richardson; Johnson & Prof. Stiglitz; Better Markets (Feb. 2012); Prof. Johnson. However, a number of commenters stated that reduced liquidity would have negative market impacts. See supra note 545 and accompanying text. 608See supra Part IV.A.3.b.2.b. 609See supra Part IV.A.3.b.2.b. As discussed above, a few other commenters suggested that to the extent liquidity is vulnerable to destabilizing liquidity spirals, any reduced liquidity
stemming from section 13 of the BHC Act and its implementing rules would not necessarily be a negative result. See AFR et al. (Feb. 2012); Public Citizen. See also Paul Volcker. These commenters also suggested that the Agencies adopt stricter conditions in the market-making exemption, as discussed throughout this Part IV.A.3. However, liquidity—essentially, the ease with which assets can be converted into cash—is not destabilizing in and of itself. Rather, liquidity spirals are a function of how firms are funded. During market downturns, when margin requirements tend to increase, firms that fund their operations with leverage face higher costs of providing liquidity; firms that run up against their maximum leverage ratios may be forced to retreat from market making, contributing to the liquidity spiral. Viewed in this light, it is institutional features of financial markets—in particular, leverage—rather than liquidity itself that contributes to liquidity spirals. 610Wider spreads can be costly for investors. For example, one commenter estimated that a 10 basis point increase in spreads in the corporate bond market would cost investors $29 billion per year. See Wellington. Wider spreads can also be particularly costly for open-end mutual funds, which must trade in and out of the fund’s portfolio holdings on a daily basis in order to satisfy redemptions and subscriptions. See Wellington; AllianceBernstein. 611A higher cost of capital increases financing costs and translates into reduced capital investment. While one commenter estimated that a one percent increase in the cost of capital would lead to a $55 to $82.5 billion decline in capital investments by U.S. nonfarm firms, the Agencies cannot independently verify these potential costs. Further, this commenter did not indicate what aspect of the proposed rule could cause a one percent increase in the cost of capital. See Thakor Study. In any event, the Agencies have made significant changes to the proposed approach to implementing the market-making exemption that should help address this commenter’s concern. 612See, e.g., CIEBA; ACLI; PNC et al.; Morgan Stanley; Chamber (Feb. 2012); Abbott Labs et al. Continued commenters.604 The Agencies believe it is useful to establish a consistent framework that will apply to all banking entities to reduce the potential for unintended competitive impacts that could arise if each banking entity is subject to an individualized plan that is tailored to its specific organizational structure and trading activities and strategies. Although the Agencies are not in the final rule modifying the basic structure of the proposed market-making exemption, certain general items suggested by commenters, such as enhanced compliance program elements and risk limits, have been incorporated in the final rule text for the marketmaking exemption, instead of a separate
appendix.605 Moreover, as described
below, the final market-making exemption includes specific substantive changes in response to a wide variety of commenter concerns. The Agencies understand that the economics of market making—and financial intermediation in general— require a market maker to be active in markets. In determining the appropriate scope of the market-making exemption, the Agencies have been mindful of commenters’ views on market making and liquidity. Several commenters stated that the proposed rule would impact a banking entity’s ability to engage in market making-related activity, with corresponding reductions in market liquidity.606 However, commenters disagreed about whether reduced liquidity would be beneficial or detrimental to the market, or if any such reductions would even materialize.607 Many commenters stated that reduced liquidity could lead to other negative market impacts, such as wider spreads, higher transaction costs, greater market volatility, diminished price discovery, and increased cost of capital. The Agencies understand that market makers play an important role in providing and maintaining liquidity throughout market cycles and that restricting market-making activity may result in reduced liquidity, with corresponding negative market impacts. For instance, absent a market maker who stands ready to buy and sell, investors may have to make large price concessions or otherwise expend resources searching for counterparties. By stepping in to intermediate trades and provide liquidity, market makers thus add value to the financial system by, for example, absorbing supply and demand imbalances. This often means taking on financial exposures, in a principal capacity, to satisfy reasonably expected near term customer demand, as well as to manage the risks associated with meeting such demand. The Agencies recognize that, as noted by commenters, liquidity can be associated with narrower spreads, lower transaction costs, reduced volatility, greater price discovery, and lower costs of capital.608 The Agencies agree with these commenters that liquidity provides important benefits to the financial system, as more liquid markets are characterized by competitive market makers, narrow bid-ask spreads, and frequent trading, and that a narrowly tailored market-making exemption could negatively impact the market by, as described above, forcing investors to make price concessions or unnecessarily expend resources searching for counterparties.609 For example, while bid-ask spreads compensate market makers for providing liquidity when asset values are uncertain, under competitive forces, dealers compete with respect to spreads, thus lowering their profit margins on a per trade basis and benefitting investors.610 Volatility is driven by both uncertainty about fundamental value and the liquidity needs of investors. When markets are illiquid, participants may have to make large price concessions to find a counterparty willing to trade, increasing the importance of the
liquidity channel for addressing volatility. If liquiditybased volatility is not diversifiable, investors will require a risk premium for holding liquidity risk, increasing the cost of capital.611 Commenters additionally suggested that the effects of diminished liquidity could be concentrated in securities markets for small or midsize companies or for lesser-known issuers, where trading is already infrequent.612 Volume in these

(Feb. 14, 2012); FEI; ICI (Feb. 2012); TMA Hong Kong; Sen. Casey. 613See, e.g., Sens. Merkley & Levin (Feb. 2012); Prof. Richardson; Better Markets (Feb. 2012); Profs. Stout & Hastings; Prof. Johnson; Occupy; Public Citizen; Profs. Admati & Pfleiderer; Better Markets (June 2012). 614See, e.g., Prof. Johnson. 615See supra note 517 (discussing commenters’ concerns regarding a trade-by-trade analysis). 616For example, by clarifying that individual trades will not be viewed in isolation and requiring strong compliance procedures, this approach will generally allow an individual trader to operate within the compliance framework established for his or her trading desk without having to assess whether each individual transaction complies with all requirements of the market-making exemption. 617See supra notes 560 and 564 and accompanying text (discussing comments on the issue of whether non-banking entities are likely to enter the market or increase their trading activities in response to reduced trading activity by banking entities). For example, one commenter stated that broker-dealers that are not affiliated with a bank would have reduced access to lender-of-last resort liquidity from the central bank, which could limit their ability to make markets during times of market stress or when capital buffers are small. See Prof. Duffie. However, another commenter noted that the presence and evolution of market making after the enactment of the Glass-Steagall Act mutes this particular concern. See Prof. Richardson. markets can be low, increasing the inventory risk of market makers. The Agencies recognize that, if the final rule creates disincentives for banking entities to provide liquidity, these low volume markets may be impacted first. As discussed above, the Agencies received several comments suggesting that the negative consequences associated with reduced liquidity would be unlikely to materialize under the proposed rule. For example, a few commenters stated that non-bank financial intermediaries, who are not subject to section 13 of the BHC Act, may increase their market-making activities in response to any reduction in market making by banking entities, a topic the Agencies discuss in more detail below.613 In addition, some commenters suggested that the restrictions on proprietary trading would support liquid markets by encouraging banking entities to focus on financial intermediation activities that supply liquidity, rather than proprietary trades that demand liquidity, such as speculative trades or trades that frontrun institutional investors.614 The statute prohibits proprietary trading activity that is not exempted. As such, the termination of nonexempt proprietary trading activities of banking entities may lead to some general reductions in liquidity of certain asset classes. Although the Agencies cannot say with any certainty, there is good reason to believe that to a significant extent the liquidity reductions of this type may be temporary
since the statute does not restrict proprietary trading activities of other market participants. Thus, over time, non-banking entities may provide much of the liquidity that is lost by restrictions on banking entities’ trading activities. If so, eventually, the detrimental effects of increased trading costs, higher costs of capital, and greater market volatility should be mitigated. Based on the many detailed comments provided, the Agencies have made substantive refinements to the market-making exemption that the Agencies believe will reduce the likelihood that the rule, as implemented, will negatively impact the ability of banking entities to engage in the types of market making-related activities permitted under the statute and, therefore, will continue to promote the benefits to investors and other market participants described above, including greater market liquidity, narrower bid-ask spreads, reduced price concessions and price impact, lower volatility, and reduced counterparty search costs, thus reducing the cost of capital. For instance, the final marketmaking exemption does not require a trade-by-trade analysis, which was a significant source of concern from commenters who represented, among other things, that a trade-by-trade analysis could have a chilling effect on individual traders’ willingness to engage in market-making activities.615 Rather, the final rule has been crafted around the overall market making-related activities of individual trading desks, with various requirements that these activities be demonstrably related to satisfying reasonably expected near term customer demands and other marketmaking activities. The Agencies believe that applying certain requirements to the aggregate risk exposure of a trading desk, along with the requirement to establish risk and inventory limits to routinize a trading desk’s compliance with the near term customer demand requirement, will reduce negative potential impacts on individual traders’ decision-making process in the normal course of market making.616 In addition, in response to a large number of comments expressing concern that the proposed market-making exemption would restrict or prohibit market making-related activities in less liquid markets, the Agencies are clarifying that the application of certain requirements in the final rule, such as the frequency of required quoting and the near term demand requirement, will account for the liquidity, maturity, and depth of the market for a given type of financial instrument. Thus, banking entities will be able to continue to engage in market making-related activities across markets and asset classes. At the same time, the Agencies recognize that an overly broad marketmaking exemption may allow banking entities to mask speculative positions as liquidity provision or related hedges. The Agencies believe the requirements included in the final rule are necessary to prevent such evasion of the marketmaking exemption, ensure compliance
with the statute, and facilitate internal banking entity and external Agency reviews of compliance with the final rule. Nevertheless, the Agencies acknowledge that these additional costs may have an impact on banking entities’ willingness to engage in market makingrelated activities. Banking entities will incur certain compliance costs in connection with their market makingrelated activities under the final rule. For example, banking entities may not currently limit their trading desks’ market-maker inventory to that which is designed not to exceed reasonably expected near term customer demand, as required by the statute. As discussed above, commenters presented diverging views on whether non-banking entities are likely to enter the market or increase their marketmaking activities if the final rule should cause banking entities to reduce their market-making activities.617 The Agencies note that prior to the GrammLeach-Bliley Act of 1999, marketmaking services were more commonly provided by non-bank-affiliated brokerdealers than by banking entities. As discussed above, by intermediating and facilitating trading, market makers provide value to the markets and profit from providing liquidity. Should banking entities retreat from making markets, the profit opportunities available from providing liquidity will provide an incentive for non-bankaffiliated broker-dealers to enter the market and intermediate trades. The Agencies are unable to assess the likely effect with any certainty, but the Agencies recognize that a marketmaking operation requires certain infrastructure and capital, which will impact the ability of non-banking entities to enter the market-making business or to increase their presence. Therefore, should banking entities retreat from making markets, there could be a transition period with reduced liquidity as non-banking entities build up the needed infrastructure and obtain capital. However, because the Agencies have substantially modified this exemption in response to comments to ensure that

618Certain non-banking entities, such as some SEC-registered broker-dealers that are not banking entities subject to the final rule, currently engage in market-making activities and, thus, should have the needed infrastructure and may attract additional capital. If the final rule has a marginal impact on banking entities’ willingness to engage in market making-related activities, these non-banking entities should be able to respond by increasing their market making-related activities. The Agencies recognize, however, that firms that do not have existing infrastructure or sufficient capital are unlikely to be able to act as market makers shortly after the final rule is implemented. Nevertheless, because some non-bank-affiliated broker-dealers currently operate market-making desks, and because it was the dominant model prior to the Gramm-Leach-Bliley Act, the Agencies believe that non-bank-affiliated financial intermediaries will be able to provide market-making services longer term. 619See proposed rule §ll.4(b)(2)(ii). 620See Joint Proposal, 76 FR 68,870 (‘‘Notably, this criterion requires that a banking entity relying on the exemption with respect to a particular transaction must actually make a market in the [financial instrument] involved; simply because a banking entity makes a market in one type of [financial instrument] does not permit it to rely on the market-making exemption for another type of [financial instrument].’’); CFTC Proposal, 77 FR 8355–8356. 621See Joint Proposal, 76 FR 68,870; CFTC Proposal, 77 FR 8356. 622See Joint Proposal, 76 FR 68,870–68,871; CFTC Proposal, 77 FR 8356. These proposed factors are generally consistent with the indicia used by the SEC to assess whether a broker-dealer is engaged in bona fide market making for purposes of Regulation SHO under the Exchange Act. See Joint Proposal, 76 FR 68,871 n.148; CFTC Proposal, 77 FR 8356 n.155. 623The Agencies noted that, with respect to this factor, the frequency of regular quotations will vary, as moderately illiquid markets may involve quotations on a daily or more frequent basis, while highly illiquid markets may trade only by appointment. See Joint Proposal, 76 FR 68,871 n.149; CFTC Proposal, 77 FR 8356 n.156. 624See Joint Proposal, 76 FR 68,871; CFTC Proposal, 77 FR 8356. 625 In the preamble to the proposed rule, the Agencies stated that the SEC’s definition of ‘‘qualified block positioner’’ may serve as guidance in determining whether a block positioner engaged in block positioning is engaged in bona fide market making for purposes of §ll.4(b)(2)(ii) of the proposed rule. See Joint Proposal, 76 FR 68,871 n.151; CFTC Proposal, 77 FR 8356 n.157. 626See Joint Proposal, 76 FR 68,871; CFTC Proposal, 77 FR 8356–8357. 627See Sens. Merkley & Levin (Feb. 2012); Alfred Brock. 628See infra Part IV.A.3.c.1.c.iii. (addressing these concerns). 629See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Morgan Stanley; Barclays; Goldman (Prop. Trading); ABA; Chamber (Feb. 2012); BDA
(Feb. 2012); Fixed Income Forum/Credit Roundtable; ACLI (Feb. 2012); T. Rowe Price; PUC Texas; PNC; MetLife; RBC; IHS; SSgA (Feb. 2012). 630See, e.g., PNC (stating that the proposed rule needs to account for market making by regional banks on behalf of small and middle-market customers whose securities are less liquid); ABA (stating that the rule should continue to permit Continued market making related to near-term customer demand is permitted as contemplated by the statute, the Agencies do not believe the final rule should significantly impact currentlyavailable market-making services.618
c. Detailed Explanation of the MarketMaking Exemption

Requirement To Routinely Stand
Ready to Purchase and Sell a. Proposed Requirement To Hold Self Out
Section ll.4(b)(2)(ii) of the
proposed rule would have required the trading desk or other organizational unit that conducts the purchase or sale in reliance on the market-making exemption to hold itself out as being willing to buy and sell, including through entering into long and short positions in, the financial instrument for its own account on a regular or continuous basis.619 The proposal stated that a banking entity could rely on the proposed exemption only for the type of financial instrument that the entity actually made a market in.620 The proposal recognized that the precise nature of a market maker’s activities often varies depending on the liquidity, trade size, market infrastructure, trading volumes and frequency, and geographic location of the market for any particular financial instrument.621 To account for these variations, the Agencies proposed indicia for assessing compliance with this requirement that differed between relatively liquid markets and less liquid markets. Further, the Agencies recognized that the proposed indicia could not be applied at all times and under all circumstances because some may be inapplicable to the specific asset class or market in which the market making-related activity is conducted. In particular, the proposal stated that a trading desk or other organizational unit’s market making-related activities in relatively liquid markets, such as equity securities or other exchangetraded instruments, should generally include: (i) Making continuous, twosided quotes and holding oneself out as willing to buy and sell on a continuous basis; (ii) a pattern of trading that includes both purchases and sales in roughly comparable amounts to provide liquidity; (iii) making continuous quotations that are at or near the market on both sides; and (iv) providing widely accessible and broadly disseminated quotes.622 With respect to market making in less liquid markets, the proposal noted that the appropriate indicia of market making-related activities will vary, but should generally include: (i) holding oneself out as willing and available to provide liquidity by providing quotes on a regular (but not necessarily continuous) basis; 623 (ii) with respect to securities, regularly purchasing securities from, or selling securities to, clients, customers, or counterparties in the secondary market; and (iii) transaction volumes and risk proportionate to historical customer liquidity and investments needs.624 In discussing this proposed requirement, the Agencies stated that bona fide market making-related activity may include certain block positioning and anticipatory position-taking. More specifically, the proposal indicated that the bona fide market making-related activity described in §ll.4(b)(2)(ii) of the proposed rule would include: (i) block positioning if undertaken by a trading desk or other organizational unit of a banking entity for the purpose of intermediating customer trading; 625 and (ii) taking positions in securities in anticipation of
customer demand, so long as any anticipatory buying or selling activity is reasonable and related to clear, demonstrable trading interest of clients, customers, or counterparties.626 b. Comments on the Proposed Requirement To Hold Self Out Commenters raised many issues regarding §ll.4(b)(2)(ii) of the proposed exemption, which would require a trading desk or other organizational unit to hold itself out as willing to buy and sell the financial instrument for its own account on a regular or continuous basis. As discussed below, some commenters viewed the proposed requirement as too restrictive, while other commenters stated that the requirement was too permissive. Two commenters expressed support for the proposed requirement.627 A number of commenters provided views on statements in the proposal regarding indicia of bona fide market making in more and less liquid markets and the permissibility of block positioning and anticipatory position-taking. Several commenters represented that the proposed requirement was too restrictive.628 For example, a number of these commenters expressed concern that the proposed requirement may limit a banking entity’s ability to act as a market maker under certain circumstances, including in less liquid markets, for instruments lacking a twosided market, or in customer-driven, structured transactions.629 In addition, a few commenters expressed specific concern about how this requirement would impact more limited marketmaking activity conducted by banks.630

banks to provide limited liquidity by buying securities that they feel are suitable for their retail and institutional customer base by stating that a bank is ‘‘holding itself out’’ when it buys and sells securities that are suitable for its customers). 631This issue is further discussed in Part IV.A.3.c.1.c.iii., infra. 632See, e.g., Goldman (Prop. Trading) (stating that it would be burdensome for a U.S. credit marketmaking business to be required to produce and disseminate quotes for thousands of individual bond CUSIPs that trade infrequently and noting that a market maker in credit markets will typically disseminate indicative prices for the most liquid instruments but, for the thousands of other instruments that trade infrequently, the market maker will generally provide a price for a trade upon request from another market participant); Morgan Stanley; SIFMA et al. (Prop. Trading) (Feb. 2012); RBC. See also BDA (Feb. 2012); FTN (stating that in some markets, such as the markets for residential mortgage-backed securities and investment grade corporate debt, a market maker will hold itself out in a subset of instruments (e.g., particular issues in the investment grade corporate debt market with heavy trading volume or that are in the midst of particular credit developments), but will trade in other instruments within the group or sector upon inquiry from customers and other dealers); Oliver Wyman (Feb. 2012) (discussing data regarding the number of U.S. corporate bonds and frequency of trading in such bonds in 2009). 633See Goldman (Prop. Trading). 634See, e.g., RBC (recommending that the Agencies clarify that a trading desk is required to hold itself out as willing to buy and sell a particular type of ‘‘product’’); SIFMA et al. (Prop. Trading) (Feb. 2012) (suggesting that the Agencies use the term ‘‘instrument,’’ rather than ‘‘covered financial position,’’ to provide greater clarity); CIEBA (supporting alternative criteria that would require a banking entity to hold itself out generally as a market maker for the relevant asset class, but not for every instrument it purchases and sells); Goldman (Prop. Trading). One of these commenters recommended that the Agencies recognize and permit the following kinds of activity in related financial instruments: (i) Options market makers should be deemed to be engaged in market making in all put and call series related to a particular underlying security and should be permitted to trade the underlying security regardless of whether such trade qualifies for the hedging exemption; (ii) convertible bond traders should be permitted to trade in the associated equity security; (iii) a market maker in one issuer’s bonds should be considered a market maker in similar bonds of other issuers; and (iv) a market maker in standardized interest rate swaps should be considered to be engaged in market making-related activity if it engages in a customized interest rate swap with a customer upon request. See RBC. 635See,
e.g., Morgan Stanley (suggesting that the Agencies add the phrase ‘‘or, in markets where regular or continuous quotes are not typically provided, the trading unit stands ready to provide quotes upon request’’); Barclays (suggesting addition of the phrase ‘‘to the extent that two-sided markets are typically made by market makers in a given product,’’ as well as changing the reference to ‘‘purchase or sale’’ to ‘‘market making-related activity’’ to avoid any inference of a trade-by-trade analysis). See also Fixed Income Forum/Credit Roundtable. To address concerns about the requirement’s application to bespoke products, one commenter suggested that the rule clearly state that a banking entity fulfills this requirement if it markets structured transactions to its client base and stands ready to enter into such transactions with customers, even though transactions may occur on a relatively infrequent basis. See JPMC. 636See Wells Fargo (Prop. Trading); RBC (supporting this approach as an alternative to removing the requirement from the rule, but primarily supporting its removal). See also ISDA (Feb. 2012) (stating that the analysis of compliance with the proposed requirement must carefully consider the degree of presence a market maker wishes to have in a given market, which may include being a leader in certain types of instruments, having a secondary presence in others, and potentially leaving or entering other submarkets). 637See SIFMA et al. (Prop. Trading) (Feb. 2012). This commenter also suggested that such test be assessed at the ‘‘trading unit’’ level. See id. 638See Goldman (Prop. Trading). 639See FTN. 640See Flynn & Fusselman; JPMorgan. 641See JPMC. 642See, e.g., Occupy; AFR et al. (Feb. 2012); Public Citizen; Johnson & Prof. Stiglitz; John Reed. See infra note 746 and accompanying text (responding to these comments). 643See Occupy. 644See Occupy; AFR et al. (Feb. 2012); Public Citizen; Johnson & Prof. Stiglitz; Sens. Merkley & Levin (Feb. 2012); John Reed. 645See AFR et al. (Feb. 2012); Occupy. 646See Occupy. 647See John Reed. 648See Johnson & Prof. Stiglitz. Many commenters indicated that it was unclear whether this provision would require a trading desk or other organizational unit to regularly or continuously quote every financial instrument in which a market is made, but expressed concern that the proposed language could be interpreted in this manner.631 These commenters noted that there are thousands of individual instruments within a given asset class, such as corporate bonds, and that it would be burdensome for a market maker to provide quotes in such a large number of instruments on a regular or continuous basis.632 One of these commenters represented that, because customer demand may be infrequent in a particular instrument, requiring a banking entity to provide regular or continuous quotes in the instrument may not provide a benefit to its customers.633 A few commenters requested that the Agencies provide further guidance on this
issue or modify the proposed standard to state that holding oneself out in a range of similar instruments will be considered to be within the scope of permitted market making-related activities.634 To address concerns about the restrictiveness of this requirement, commenters suggested certain modifications. For example, some commenters suggested adding language to the requirement to account for market making in markets that do not typically involve regular or continuous, or twosided, quoting.635 In addition, a few commenters requested that the requirement expressly include transactions in new instruments or transactions in instruments that occur infrequently to address situations where a banking entity may not have previously had the opportunity to hold itself out as willing to buy and sell the applicable instrument.636 Other commenters supported alternative criteria for assessing whether a banking entity is acting as a market maker, such as: (i) a willingness to respond to customer demand by providing prices upon request; 637 (ii) being in the business of providing prices upon request for that financial instrument or other financial instruments in the same or similar asset class or product class; 638 or (iii) a historical test of market-making activity, with compliance judged on the basis of actual trades.639 Finally, two commenters stated that this requirement should be moved to Appendix B of the rule,640 which, according to one of these commenters, would provide the Agencies greater flexibility to consider the facts and circumstances of a particular activity.641 Other commenters took the view that the proposed requirement was too permissive.642 For example, one commenter stated that the proposed standard provided too much room for interpretation and would be difficult to measure and monitor. This commenter expressed particular concern that a trading desk or other organizational unit could meet this requirement by regularly or continuously making wide, out of context quotes that do not present any real risk of execution and do not contribute to market liquidity.643 Some commenters suggested the Agencies place greater restrictions on a banking entity’s ability to rely on the marketmaking exemption in certain illiquid markets, such as assets that cannot be reliably valued, products that do not have a genuine external market, or instruments for which a banking entity does not expect to have customers wishing to both buy and sell.644 In support of these requests, commenters stated that trading in illiquid products raises certain concerns under the rule, including: a lack of reliable data for purposes of using metrics to monitor a banking entity’s market making-related activity (e.g., products whose valuations are determined by an internal model that can be manipulated, rather than an observable market price); 645 relation to the last financial crisis; 646 lack of important benefits to the real economy; 647 similarity to prohibited proprietary
trading; 648 and inconsistency with the statute’s requirements that market makingrelated activity must be ‘‘designed not to exceed the reasonably expected near

649See Sens. Merkley & Levin (Feb. 2012) (stating that a banking entity must have or reasonably expect at least two customers—one for each side of the trade—and must have a reasonable expectation of the second customer coming to take the position or risk off its books in the ‘‘near term’’); AFR et al. (Feb. 2012); Public Citizen. 650See AFR et al. (Feb. 2012) (stating that the rule should ban market making in illiquid and opaque securities with no genuine external market, but permit market making in somewhat illiquid securities, such as certain corporate bonds, as long as the securities can be reliably valued with reference to other extremely similar securities that are regularly traded in liquid markets and the financial outcome of the transaction is reasonably predictable); Johnson & Prof. Stiglitz (recommending that permitted market making be limited to assets that can be reliably valued in, at a minimum, a moderately liquid market evidenced by trading within a reasonable period, such as a week, through a real transaction and not simply with interdealer trades); Public Citizen (stating that market making should be limited to assets that can be reliably valued in a market where transactions take place on a weekly basis). 651See AFR et al. (Feb. 2012) (stating that such a limitation would be consistent with the proposed limitation on ‘‘high-risk assets’’ and the discussion of this limitation in proposed Appendix C); Public Citizen; Prof. Richardson. 652See Prof. Richardson. 653Two commenters recommended that banking entities be required to treat trading in assets that cannot be reliably valued and that trade only by appointment, such as bespoke derivatives and structured products, as providing an illiquid bespoke loan, which are subject to higher capital charges under the Federal banking agencies’ capital rules. See Johnson & Prof. Stiglitz; John Reed. Another commenter suggested that, if not directly prohibited, trading in bespoke instruments that cannot be reliably valued should be assessed an appropriate capital charge. See Public Citizen. 654See Occupy. This commenter further suggested that the exemption exclude all activities that include: (i) Assets whose changes in value cannot be mitigated by effective hedges; (ii) new products with rapid growth, including those that do not have a market history; (iii) assets or strategies that include significant imbedded leverage; (iv) assets or strategies that have demonstrated significant historical volatility; (v) assets or strategies for which the application of capital and liquidity standards would not adequately account for the risk; and (vi) assets or strategies that result in large and significant concentrations to sectors, risk factors, or counterparties. See id. 655See AFR et al. (Feb. 2012); Johnson & Prof. Stiglitz. 656See supra Part IV.A.3.c.1.a. 657See Occupy; AFR et al. (Feb. 2012); NYSE Euronext (expressing support for the indicia set forth in the FSOC study, which are substantially the
same as the indicia in the proposal); Alfred Brock. 658See AFR et al. (Feb. 2012). 659See Goldman (Prop. Trading); SIFMA et al. (Prop. Trading) (Feb. 2012). 660See ICI (Feb. 2012); ICI Global. 661See supra Part IV.A.3.c.1.a. 662See Alfred Brock. 663See supra note 629 accompanying text. With respect to this factor, one commenter requested that the Agencies delete the parenthetical of ‘‘but not necessarily continuous’’ from the proposed factor as
part of a broader effort to recognize the relative
illiquidity of swap markets. See ISDA (Feb. 2012). term demands of clients, customers, or counterparties’’ and must not result in a material exposure to high-risk assets or high-risk trading strategies.649 These commenters also requested that the proposed requirement be modified in certain ways. In particular, several commenters stated that the proposed exemption should only permit market making in assets that can be reliably valued through external market transactions.650 In order to implement such a limitation, three commenters suggested that the Agencies prohibit banking entities from market making in assets classified as Level 3 under FAS
157.651 One of these commenters
explained that Level 3 assets are generally highly illiquid assets whose fair value cannot be determined using either market prices or models.652 In addition, a few commenters suggested that banking entities be subject to additional capital charges for market making in illiquid products.653 Another commenter stated that the Agencies should require all market makingrelated activity to be conducted on a multilateral organized electronic trading platform or exchange to make it possible to monitor and confirm certain trading data.654 Two commenters emphasized that their recommended restrictions on market making in illiquid markets should not prohibit banking entities from making markets in corporate bonds.655
i. The Proposed Indicia
As noted above, the proposal set forth certain indicia of bona fide market making-related activity in liquid and less liquid markets that the Agencies proposed to apply when evaluating whether a banking entity was eligible for the proposed exemption.656 Several commenters provided their views regarding the effectiveness of the proposed indicia. With respect to the proposed indicia for liquid markets, a few commenters expressed support for the proposed indicia.657 One of these commenters stated that while the proposed factors are reasonably consistent with bona fide market making, the Agencies should add two other factors: (i) A willingness to transact in reasonable quantities at quoted prices, and (ii) inventory turnover.658 Other commenters, however, stated that the proposed use of factors from the SEC’s analysis of bona fide market making under Regulation SHO was inappropriate in this context. In particular, these commenters represented that bona fide market making for purposes of Regulation SHO is a purposefully narrow concept that permits a subset of market makers to qualify for an exception from the ‘‘locate’’ requirement in Rule 203 of Regulation SHO. The commenters further expressed the belief that the policy goals of section 13 of the BHC Act do not necessitate a similarly narrow interpretation of market making.659 A few commenters expressed particular concern about how the factor regarding patterns of purchases and sales in roughly comparable amounts would apply to market making in exchange-traded funds (‘‘ETFs’’). According to these commenters, demonstrating this factor could be difficult because ETF market making involves a pattern of purchases and sales of groups of equivalent securities (i.e., the ETF shares and the basket of securities and cash that is exchanged for them), not a single security. In addition, the commenters were unsure whether this factor could be demonstrated in times of limited trading in ETF shares.660 The preamble to the proposed rule also provided certain proposed indicia of bona fide market making-related activity in less liquid markets.661 As discussed above, commenters had differing views about whether the exemption for market making-related activity should permit banking entities to engage in market making in some or all illiquid markets. Thus, with respect to the proposed indicia for market making in less liquid markets, commenters generally stated that the indicia should be broader or narrower, depending on the commenter’s overall view on the issue of market making in illiquid markets. One commenter stated that the proposed indicia are effective.662 The first proposed factor of market making-related activity in less liquid markets was holding oneself out as willing and available to provide liquidity by providing quotes on a regular (but not necessarily continuous) basis. As noted above, several commenters expressed concern about a requirement that market makers provide regular quotations in less liquid
instruments, including in fixed income markets and bespoke, customized derivatives.663 With respect to the interaction between the rule language requiring ‘‘regular’’ quoting and the proposal’s language permitting trading by appointment under certain circumstances, some of these commenters expressed uncertainty about how a market maker trading only by appointment would be able to satisfy the proposed rule’s regular quotation

664See SIFMA et al. (Prop. Trading) (Feb. 2012); CIEBA. These commenters requested greater clarity or guidance on the meaning of ‘‘regular’’ in the instance of a market maker trading only by appointment. See id. 665See Goldman (Prop. Trading). 666See Public Citizen; Occupy. One of these commenters further noted that most markets lack a structural framework that would enable monitoring of compliance with this requirement. See Occupy. 667See, e.g., Sens. Merkley & Levin (Feb. 2012); Johnson & Prof. Stiglitz; John Reed; Public Citizen. 668See, e.g., John Reed; Public Citizen. 669See AFR et al. (Feb. 2012); Occupy. 670See AFR et al. (Feb. 2012) 671See Occupy. 672See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); Occupy. 673See Goldman (Prop. Trading). 674See Occupy. 675See Joint Proposal, 76 FR 68,871. 676See, e.g., RBC; SIFMA (Asset Mgmt.) (Feb. 2012); Goldman (Prop. Trading). See also infra note 735 (responding to these comments). 677See RBC (expressing concern about fire sales); SIFMA (Asset Mgmt.) (Feb. 2012) (expressing concern about fire sales, particularly in less liquid markets where a block position would overwhelm the market and undercut the price a market maker can obtain); Goldman (Prop. Trading) (representing that this requirement could create uncertainty about whether a longer unwind would be permissible and, if so, under what circumstances). 678See Goldman (Prop. Trading). 679See RBC. 680See SIFMA (Asset Mgmt.) (Feb. 2012); Fidelity (requesting that the Agencies explicitly recognize that block trades qualify for the market-making exemption); Oliver Wyman (Feb. 2012). 681See SIFMA (Asset Mgmt.) (Feb. 2012). 682See Oliver Wyman (Feb. 2012). This commenter estimated that investors trading out of large block positions on their own, without a market maker directly providing liquidity, would have to pay incremental transaction costs between $1.7 and $3.4 billion per year. This commenter estimated a block trading size of $850 billion, based on a haircut of total block trading volume reported for NYSE and Nasdaq. The commenter then estimated, based on market interviews and analysis of standard market impact models provided by dealers, that the market impact of executing large block orders without direct market maker liquidity provision would be the difference between the market impact costs of executing a block trade over a 5-day period versus a 1-day period—which would be approximately 20 to 50 basis points, depending on the size of the trade. See id. requirement.664 In addition, another commenter stated that the proposal’s recognition of trading by appointment does not alleviate concerns about applying the ‘‘regular’’ quotation requirement to market making in less liquid instruments in markets that are not, as a whole, highly illiquid, such as credit and interest rate markets.665 Other commenters expressed concern about only requiring a market maker to provide regular quotations or permitting trading by appointment to
qualify for the market-making exemption. With respect to regular quotations, some commenters stated that such a requirement enables evasion of the prohibition on proprietary trading because a proprietary trader may post a quote at a time of little interest in a financial product or may post wide, out of context quotes on a regular basis with no real risk of execution.666 Several commenters stated that trading only by appointment should not qualify as market making for purposes of the proposed rule.667 Some of these commenters stated that there is no ‘‘market’’ for assets that trade only by appointment, such as customized, structured products and OTC derivatives.668 The second proposed criterion for market making-related activity in less liquid markets was, with respect to securities, regularly purchasing securities from, or selling securities to, clients, customers, or counterparties in the secondary market. Two commenters expressed concern about this proposed factor.669 In particular, one of these commenters stated that the language is fundamentally inconsistent with market making because it contemplates that only taking one side of the market is sufficient, rather than both buying and selling an instrument.670 The other commenter expressed concern that banking entities would be allowed to accumulate a significant amount of illiquid risk because the indicia for market making-related activity in less liquid markets did not require a market maker to buy and sell in comparable amounts (as required by the indicia for liquid markets).671 Finally, the third proposed factor of market making in less liquid markets would consider transaction volumes and risk proportionate to historical customer liquidity and investment needs. A few commenters indicated that there may not be sufficient information available for a banking entity to conduct such an analysis.672 For example, one commenter stated that historical information may not necessarily be available for new businesses or developing markets in which a market maker may seek to establish trading operations.673 Another commenter expressed concern that this factor would not help differentiate market making from prohibited proprietary trading because most illiquid markets do not have a source for such historical risk and volume data.674
ii. Treatment of Block Positioning
Activity
The proposal provided that the activity described in §ll.4(b)(2)(ii) of the proposed rule would include block positioning if undertaken by a trading desk or other organizational unit of a banking entity for the purpose of intermediating customer trading.675 A number of commenters supported the general language in the proposal permitting block positioning, but expressed concern about the reference to the definition of ‘‘qualified block positioner’’ in SEC Rule 3b–8(c).676 With respect to using Rule 3b–8(c) as guidance under the proposed rule, these commenters represented that Rule 3b– 8(c)’s requirement to resell block positions ‘‘as rapidly as possible’’ would cause negative results (e.g., fire sales) or create market uncertainty (e.g., when, if ever, a longer unwind would be permitted).677 According to one of these commenters, gradually disposing of a large long position purchased from a customer may be the best means of reducing near term price volatility associated with the supply shock of trying to sell the position at once.678 Another commenter expressed concern about the second requirement of Rule 3b–8(c), which provides that the dealer must determine in the exercise of reasonable diligence that the block cannot be sold to or purchased from others on equivalent or better terms. This commenter stated that this kind of determination would be difficult in less liquid markets because those markets do not have widely disseminated quotes that dealers can use for purposes of comparison.679 Beyond the reference to Rule 3b–8(c), a few commenters expressed more general concern about the proposed rule’s application to block positioning activity.680 One commenter noted that the proposal only discussed block positioning in the context of the proposed requirement to hold oneself out, which implies that block positioning activity also must meet the other requirements of the marketmaking exemption. This commenter requested an explicit recognition that banking entities meet the requirements of the market-making exemption when they enter into block trades for customers, including related trades entered to support the block, such as hedging transactions.681 Finally, one commenter expressed concern that the inventory metrics in proposed
Appendix A would make dealers
reluctant to execute large, principal transactions because such trades would have a transparent impact on inventory metrics in the relevant asset class.682
iii. Treatment of Anticipatory Market
Making
In the proposal, the Agencies proposed that ‘‘bona fide market making-related activity may include taking positions in securities in

683 Joint Proposal, 76 FR 68,871; CFTC Proposal, 77 FR 8356–8357. 684See, e.g., SIFMA et al. (Prop. Trading) (Feb.
2012) (expressing concern that requiring trades to
be related to clear demonstrable trading interest could curtail the market-making function by removing a market maker’s discretion to develop inventory to best serve its customers and adversely restrict liquidity); Goldman (Prop. Trading); Chamber (Feb. 2012); Comm. on Capital Markets Regulation. See also Morgan Stanley (requesting certain revisions to more closely track the statute); SIFMA (Asset Mgmt.) (Feb. 2012) (expressing general concern that the standard creates limitations on a market maker’s inventory). These comments are addressed in Part IV.A.3.c.2., infra. 685See Goldman (Prop. Trading); Occupy. See also Public Citizen (expressing general concern that accumulating positions in anticipation of demand opens issues of front running). 686See Goldman (Prop. Trading). 687See Occupy. 688See Goldman (Prop. Trading); ISDA (Feb. 2012); SIFMA et al. (Prop. Trading) (Feb. 2012). 689See BoA (stating that a market maker must acquire inventory in advance of express customer demand and customers expect a market maker’s inventory to include not only the financial instruments in which customers have previously traded, but also instruments that the banking entity believes they may want to trade); Occupy. 690See Morgan Stanley (suggesting a new standard providing that a purchase or sale must be ‘‘reasonably consistent with observable customer demand patterns and, in the case of new asset classes or markets, with reasonably expected future developments on the basis of the trading unit’s client relationships’’); Chamber (Feb. 2012) (requesting that the final rule permit market makers to make individualized assessments of anticipated customer demand based on their expertise and experience in the markets and make trades according to those assessments); Goldman (Prop. Trading) (recommending that the Agencies instead focus on how trading activities are ‘‘designed’’ to meet the reasonably expected near term demands of clients over time, rather than whether those demands have actually manifested themselves at a given point in time); ISDA (Feb. 2012) (stating that the Agencies should clarify this language to recognize differences between liquid and illiquid markets and noting that illiquid and low volume markets necessitate that swap dealers take a longer and broader view than dealers in liquid markets). 691See, e.g., Better Markets (Feb. 2012); Occupy; Public Citizen. 692See Better Markets (Feb. 2012). See also infra note 742 (addressing this issue). 693See Occupy. 694See supra Part IV.A.3.c.1.b. (discussing comments on this issue). The Agencies did not intend for the reference to ‘‘covered financial position’’ in the proposed rule to imply a single instrument, although commenters contended that the proposal may not have been sufficiently clear on this point. 695 Joint Proposal, 76 FR 68,871; CFTC Proposal, 77 FR 8356. anticipation of customer demand, so long as any anticipatory buying or selling activity is reasonable and related to clear, demonstrable trading
interest of clients, customers, or counterparties.’’ 683 Many commenters indicated that the language in the proposal is inconsistent with the statute’s language regarding near term demands of clients, customers, or counterparties. According to these commenters, the statute’s ‘‘designed’’ and ‘‘reasonably expected’’ language expressly acknowledges that a market maker may need to accumulate inventory before customer demand manifests itself. Commenters further represented that the proposed standard may unduly limit a banking entity’s ability to accumulate inventory in anticipation of customer demand.684 In addition, two commenters expressed concern that the proposal’s language would effectively require a banking entity to engage in impermissible front running.685 One of these commenters indicated that the Agencies should not restrict anticipatory trading to such a short time period.686 To the contrary, the other commenter stated that anticipatory accumulation of inventory should be considered to be prohibited proprietary trading.687 A few commenters noted that the standard in the proposal explicitly refers to securities and requested that the reference be changed to encompass the full scope of financial instruments covered by the rule to avoid ambiguity.688 Several commenters recommended that the language be eliminated 689 or modified 690 to address the concerns discussed above.
iv. High-Frequency Trading
A few commenters stated that highfrequency trading should be considered prohibited proprietary trading under the rule, not permitted market makingrelated activity.691 For example, one commenter stated that the Agencies should not confuse high volume trading and market making. This commenter emphasized that algorithmic traders in general—and high-frequency traders in particular—do not hold themselves out in the manner required by the proposed rule, but instead only offer to buy and sell when they think it is profitable.692 Another commenter suggested the Agencies impose a resting period on any order placed by a banking entity in reliance on any exemption in the rule by, for example, prohibiting a banking entity from buying and subsequently selling a position within a span of two seconds.693
c. Final Requirement To Routinely
Stand Ready To Purchase And Sell
Section ll.4(b)(2)(i) of the final rule
provides that the trading desk that establishes and manages the financial exposure must routinely stand ready to purchase and sell one or more types of financial instruments related to its financial exposure and be willing and available to quote, buy and sell, or otherwise enter into long and short positions in those types of financial instruments for its own account, in commercially reasonable amounts and throughout market cycles, on a basis appropriate for the liquidity, maturity, and depth of the market for the relevant types of financial instruments. As discussed in more detail below, the standard of ‘‘routinely’’ standing ready to purchase and sell one or more types of financial instruments will be interpreted to account for differences across markets and asset classes. In addition, this requirement provides that a trading desk must be willing and available to provide quotations and transact in the particular types of financial instruments in commercially reasonable amounts and throughout market cycles. Thus, a trading desk’s activities would not meet the terms of the market-making exemption if, for example, the trading desk only provides wide quotations on one or both sides of the market relative to prevailing market conditions or is only willing to trade on an irregular, intermittent basis. While this provision of the marketmaking exemption has some similarity to the requirement to hold oneself out in §ll.4(b)(2)(ii) of the proposed rule, the Agencies have made a number of refinements in response to comments. Specifically, a number of commenters expressed concern that the proposed requirement did not sufficiently account for differences between markets and asset classes and would unduly limit certain types of market making by requiring ‘‘regular or continuous’’ quoting in a particular instrument.694 The explanation of this requirement in the proposal was intended to address many of these concerns. For example, the Agencies stated that the proposed ‘‘indicia cannot be applied at all times and under all circumstances because some may be inapplicable to the specific asset class or market in which the market-making activity is conducted.’’ 695 Nonetheless, the Agencies believe that certain modifications are warranted to clarify the rule and to prevent a potential chilling effect on market making-related activities conducted by banking entities. Commenters represented that the requirement that a trading desk hold itself out as being willing to buy and sell ‘‘on a regular or continuous basis,’’ as was originally proposed, was impossible

696See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Morgan Stanley; Barclays; Goldman (Prop. Trading); ABA; Chamber (Feb. 2012); BDA (Feb. 2012); Fixed Income Forum/Credit Roundtable; ACLI (Feb. 2012); T. Rowe Price; PUC Texas; PNC; MetLife; RBC; SSgA (Feb. 2012). Some commenters suggested alternative criteria, such as providing prices upon request, using a historical test of market making, or a purely guidance-based approach. See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); FTN; Flynn & Fusselman; JPMC. The Agencies are not adopting a requirement that the trading desk only provide prices upon request because the Agencies believe it would be inconsistent with market making in liquid exchange-traded instruments where market makers regularly or continuously post quotes on an exchange. With respect to one commenter’s suggested approach of a historical test of market making, this commenter did not provide enough information about how such a test would work for the Agencies’ consideration. Finally, the final rule does not adopt a purely guidance-based approach because, as discussed further above, the Agencies believe it could lead to an increased risk of evasion. 697See Further Definition of ‘‘Swap Dealer,’’ ‘‘Security-Based Swap Dealer,’’ ‘‘Major Swap Participant,’’ ‘‘Major Security-Based Swap Participant’’ and ‘‘Eligible Contract Participant’’, 77 FR 30596, 30609 (May 23, 2012) (describing market making in swaps as ‘‘routinely standing ready to enter into swaps at the request or demand of a counterparty’’). 698As a result, activity that is considered market making under this final rule may not necessarily be considered market making for purposes of other laws or regulations, such as the U.S. securities laws, the rules and regulations thereunder, or selfregulatory organization rules. In addition, the Agencies note that a banking entity acting as an underwriter would continue to be treated as an underwriter for purposes of the securities laws and the regulations thereunder, including any liability arising under the securities laws as a result of acting in such capacity, regardless of whether it is able to meet the terms of the market-making exemption for its activities. See Sens. Merkley & Levin (Feb. 2012). 699See Joint Proposal, 76 FR 68,957; CFTC Proposal, 77 FR 8436. 700See Wellington; SIFMA et al. (Prop. Trading) (Feb. 2012). 701Morgan Stanley. 702See Joint Proposal, 76 FR 68,957 n.2. 703See, e.g., Occupy (expressing concern that, with respect to the proposed definition of ‘‘trading unit,’’ an ‘‘oversized’’ unit could combine significantly unrelated trading desks, which would impede detection of proprietary trading activity). 704The Agencies recognize that the proposed rule’s application to a trading desk ‘‘or other organizational unit’’ would have provided banking entities with this type of flexibility to determine the level of organization at which the market-making exemption should apply based on the entity’s
particular business structure and trading strategies, which would likely reduce the burdens of this aspect of the final rule. However, for the reasons noted above regarding application of this exemption to a higher organizational level than the trading desk, the Agencies are not adopting the ‘‘or other organizational unit’’ language. to meet or impractical in the context of many markets, especially less liquid markets.696 Accordingly, the final rule requires a trading desk that establishes and manages the financial exposure to ‘‘routinely’’ stand ready to trade one or more types of financial instruments related to its financial exposure. As discussed below, the meaning of ‘‘routinely’’ will account for the liquidity, maturity, and depth of the market for a type of financial instrument, which should address commenter concern that the proposed standard would not work in less liquid markets and would have a chilling effect on banking entities’ ability to act as market makers in less liquid markets. A concept of market making that is applicable across securities, commodity futures, and derivatives markets has not previously been defined by any of the Agencies. Thus, while this standard is based generally on concepts from the securities laws and is consistent with the CFTC’s and SEC’s description of market making in swaps,697 the Agencies note that it is not directly based on an existing definition of market making.698 Instead, the approach taken in the final rule is intended to take into account and accommodate the conditions in the relevant market for the financial instrument in which the banking entity is making a market.
i. Definition of ‘‘Trading Desk’’
The Agencies are adopting a marketmaking exemption with requirements that generally focus on a financial exposure managed by a ‘‘trading desk’’ of a banking entity and such trading desk’s market-maker inventory. The market-making exemption as originally proposed would have applied to ‘‘a trading desk or other organizational unit’’ of a banking entity. In addition, for purposes of the proposed requirement to report and record certain quantitative measurements, the proposal defined the term ‘‘trading unit’’ as each of the following units of organization of a banking entity: (i) Each discrete unit that is engaged in the coordinated implementation of a revenue-generation strategy and that participates in the execution of any covered trading activity; (ii) each organizational unit that is used to structure and control the aggregate risk-taking activities and employees of one or more trading units described in paragraph (i); and (iii) all trading operations, collectively.699 The Agencies received few comments regarding the organizational level at which the requirements of the marketmaking exemption should apply, and many of the commenters that addressed this issue did not describe their suggested approach in detail.700 One commenter suggested that the marketmaking exemption apply to each ‘‘trading unit’’ of a banking entity, defined as ‘‘each organizational unit that is used to structure and control the aggregate risk-taking activities and employees that are engaged in the coordinated implementation of a customer-facing revenue generation strategy and that participate in the execution of any covered trading activity.’’ 701 This suggested approach is substantially similar to the second prong of the Agencies’ proposed definition of ‘‘trading unit’’ in Appendix A of the proposal. The Agencies described this prong as generally including management or reporting divisions, groups, sub-groups, or other intermediate units of organization used by the banking entity to manage one or more discrete trading units (e.g., ‘‘North American Credit Trading,’’ ‘‘Global Credit Trading,’’ etc.).702 The Agencies are concerned that this commenter’s suggested approach, or any other approach applying the exemption’s requirements to a higher level of organization than the trading desk, would impede monitoring of market making-related activity and detection of impermissible proprietary trading by combining a number of different trading strategies and aggregating a larger volume of trading activities.703 Further, key requirements in the market-making exemption, such as the required limits and risk management procedures, are generally used by banking entities for risk control and applied at the trading desk level. Thus, applying them at a broader organizational level than the trading desk would create a separate system for compliance with this exemption designed to permit a banking entity to aggregate disparate trading activities and apply limits more generally. Applying the
conditions of the exemption at a more aggregated level would allow banking entities more flexibility in trading and could result in a higher volume of trading that could contribute modestly to liquidity.704 Instead of taking that approach, the Agencies have determined to permit a broader range of market making-related activities that can be effectively controlled by building on risk controls used by trading desks for business purposes. This will allow an individual trader to use instruments or strategies within limits established in the compliance program to confidently trade in the type of financial instruments in which his or her trading desk makes a market. The Agencies believe this addresses concerns that uncertainty would negatively impact liquidity. It also addresses concerns that applying the market-making exemption at a higher level of organization would reduce the effectiveness of the requirements in the final rule aimed at ensuring that the quality and character of trading is consistent with market

705See final rule §ll.3(e)(13).
706For example, the Agencies expect a banking entity may determine the foreign exchange options desk to be a trading desk; however, the Agencies do not expect a banking entity to consider an individual Japanese Yen options trader (i.e., the trader in charge of all Yen-based options trades) as a trading desk, unless the banking entity manages its profit and loss, market making, and hedging in Japanese Yen options independently of all other financial instruments. 707See infra note 724 and accompanying text. Several commenters noted that market-making activities may be conducted across separate affiliated legal entities. See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading). 708See infra note 727 and accompanying text. making-related activity and would increase the risk of evasion. Moreover, several provisions of the final rule are intended to account for the liquidity, maturity, and depth of the market for a given type of financial instrument in which the trading desk makes a market. The final rule takes account of these factors to, among other things, respond to commenters’ concerns about the proposed rule’s potential impact on market making in less liquid markets. Applying these requirements at an organizational level above the trading desk would be more likely to result in aggregation of trading in various types of instruments with differing levels of liquidity, which would make it more difficult for these market factors to be taken into account for purposes of the exemption (for example, these factors are considered for purposes of tailoring the analysis of reasonably expected near term demands of customers and establishing risk, inventory, and duration limits). Thus, the Agencies continue to believe that certain requirements of the exemption should apply to a relatively granular level of organization within a banking entity (or across two or more affiliated banking entities). These requirements of the final market-making exemption have been formulated to best reflect the nature of activities at the trading desk level of granularity. As explained below, the Agencies are applying certain requirements to a ‘‘trading desk’’ of a banking entity and adopting a definition of this term in the final rule.705 The definition of ‘‘trading desk’’ is similar to the first prong of the proposed definition of ‘‘trading unit.’’ The Agencies are not adopting the proposed ‘‘or other organizational unit’’ language because the Agencies are concerned that approach would have provided banking entities with too much discretion to independently determine the organizational level at which the requirements should apply, including a more aggregated level of organization, which could lead to evasion of the general prohibition on proprietary trading and the other concerns noted above. The Agencies believe that adopting an approach focused on the trading desk level will allow banking entities and the Agencies to better distinguish between permitted
market making-related activities and trading that is prohibited by section 13 of the BHC Act and, thus, will prevent evasion of the statutory requirements, as discussed in more detail below. Further, as discussed below, the Agencies believe that applying requirements at the trading desk level is balanced by the financial exposure-based approach, which will address commenters’ concerns about the burdens of trade-bytrade analyses. In the final rule, trading desk is defined to mean the smallest discrete unit of organization of a banking entity that buys or sells financial instruments for the trading account of the banking entity or an affiliate thereof. The Agencies expect that a trading desk would be managed and operated as an individual unit and should reflect the level at which the profit and loss of market-making traders is attributed.706 The geographic location of individual traders is not dispositive for purposes of the analysis of whether the traders may comprise a single trading desk. For instance, a trading desk making markets in U.S. investment grade telecom corporate credits may use trading personnel in both New York (to trade U.S. dollar-denominated bonds issued by U.S.-incorporated telecom companies) and London (to trade Eurodenominated bonds issued by the same type of companies). This approach allows more effective management of risks of trading activity by requiring the establishment of limits, management oversight, and accountability at the level where trading activity actually occurs. It also allows banking entities to tailor the limits and procedures to the type of instruments traded and markets served by each trading desk. In response to comments, and as discussed below in the context of the ‘‘financial exposure’’ definition, a trading desk may manage a financial exposure that includes positions in different affiliated legal entities.707 Similarly, a trading desk may include employees working on behalf of multiple affiliated legal entities or booking trades in multiple affiliated entities. Using the previous example, the U.S. investment grade telecom corporate credit trading desk may include traders working for or booking into a broker-dealer entity (for corporate bond trades), a security-based swap dealer entity (for single-name CDS trades), and/or a swap dealer entity (for index CDS or interest rate swap hedges). To clarify this issue, the definition of ‘‘trading desk’’ specifically provides that the desk can buy or sell financial instruments ‘‘for the trading account of a banking entity or an affiliate thereof.’’ Thus, a trading desk need not be constrained to a single legal entity, although it is permissible for a trading desk to only trade for a single legal entity. A trading desk booking positions in different affiliated legal entities must have records that identify all positions included in the trading desk’s financial exposure and where such positions are held, as discussed below.708 The Agencies believe that
establishing a defined organizational level at which many of the market-making exemption’s requirements apply will address potential evasion concerns. Applying certain requirements of the marketmaking exemption at the trading desk level will strengthen their effectiveness and prevent evasion of the exemption by ensuring that the aggregate trading activities of a relatively limited group of traders on a single desk are conducted in a manner that is consistent with the exemption’s standards. In particular, because many of the requirements in the market-making exemption look to the specific type(s) of financial instruments in which a market is being made, and such requirements are designed to take into account differences among markets and asset classes, the Agencies believe it is important that these requirements be applied to a discrete and identifiable unit engaged in, and operated by personnel whose responsibilities relate to, making a market in a specific set or type of financial instruments. Further, applying requirements at the trading desk level should facilitate banking entity monitoring and review of compliance with the exemption by limiting the aggregate trading volume that must be reviewed, as well as allowing consideration of the particular facts and circumstances of the desk’s trading activities (e.g., the liquidity, maturity, and depth of the market for the relevant types of financial instruments). As discussed above, the Agencies believe that applying the requirements of the market-making exemption to a higher level of organization would reduce the ability to consider the liquidity, maturity, and depth of the market for a type of financial instrument, would impede effective monitoring and compliance reviews, and would increase the risk of evasion.

709See proposed rule §ll.4(b).
710Some commenters also contended that language in proposed Appendix B raised transaction-by-transaction implications. See supra notes 517 to 524 and accompanying text (discussing commenters’ transaction-by-transaction concerns). 711The Agencies are not adopting a transactionby-transaction approach because the Agencies are concerned that such an approach would be unduly burdensome or impractical and inconsistent with the manner in which bona fide market makingrelated activity is conducted. Additionally, the Agencies are concerned that the burdens of such an approach would cause banking entities to significantly reduce or cease market making-related activities, which would cause negative market impacts harmful to both investors and issuers, as well as the financial system generally. 712See Joint Proposal, 76 FR 68,870 n.146 (‘‘The Agencies note that a market maker may often make a market in one type of [financial instrument] and hedge its activities using different [financial instruments] in which it does not make a market.’’); CFTC Proposal, 77 FR 8356 n.152. 713See final rule §ll.4(b)(2)(iv). 714See final rule §ll.4(b)(2)(iii)(E). 715See final rule §ll.4(b)(5). 716As noted in the proposal, certain types of market making-related activities, such as market making in derivatives, involves the retention of principal exposures rather than the retention of actual financial instruments. See Joint Proposal, 76 FR 68,869 n.143; CFTC Proposal, 77 FR 8354 n.149. This type of activity would be included under the concept of ‘‘inventory’’ in the final rule. 717The Agencies recognize that under the statute a banking entity’s positions in loans, spot commodities, and spot foreign exchange or currency are not subject to the final rule’s restrictions on proprietary trading. Thus, a banking entity’s trading in these instruments does not need to comply with the market-making exemption or any other exemption to the prohibition on proprietary trading. A banking entity may, however, include exposures in loans, spot commodities, and spot foreign exchange or currency that are related to the desk’s market-making activities in determining the trading desk’s financial exposure and in turn, the desk’ s financial exposure limits under the market-making exemption. The Agencies believe this will provide a more accurate picture of the trading desk’s financial exposure. For example, a market maker in foreign exchange forwards or swaps may mitigate the risks of its market-maker inventory with spot foreign exchange.
ii. Definitions of ‘‘Financial Exposure’’
and ‘‘Market-Maker Inventory’’ Certain requirements of the proposed market-making exemption referred to a ‘‘purchase or sale of a [financial instrument].’’ 709 Even though the Agencies did not intend to require a trade-by-trade review, a significant number of commenters expressed concern that this language could be read to require compliance with the proposed market-making exemption on a transaction-by-transaction basis.710 In response to these concerns, the Agencies are modifying the exemption to clarify the manner in which compliance with certain provisions will be assessed. In particular, rather than a transaction-by-transaction focus, the market-making exemption in the final rule focuses on two related aspects of market-making activity: A trading desk’s ‘‘market-maker inventory’’ and its overall ‘‘financial exposure.’’ 711 The Agencies are adopting an approach that focuses on both a trading desk’s financial exposure and marketmaker inventory in recognition that market making-related activity is best viewed in a holistic manner and that, during a single day, a trading desk may engage in a large number of purchases and sales of financial instruments. While all these transactions must be conducted in compliance with the market-making exemption, the Agencies recognize that they involve financial instruments for which the trading desk acts as market maker (i.e., by standing ready to purchase and sell that type of financial instrument) and instruments that are acquired to manage the risks of positions in financial instruments for which the desk acts as market maker, but in which the desk is not itself a market maker.712 The final rule requires that activity by a trading desk under the market-making exemption be evaluated by a banking entity through monitoring and setting limits for the trading desk’s marketmaker inventory and financial exposure. The market-maker inventory of a trading desk includes the positions in financial instruments, including derivatives, in which the trading desk acts as market maker. The financial exposure of the trading desk includes the aggregate risks of financial instruments in the marketmaker inventory of the trading desk plus the financial instruments, including derivatives, that are acquired to manage the risks of the positions in financial instruments for which the trading desk acts as a market maker, but in which the trading desk does not itself make a market, as well as any associated loans, commodities, and foreign exchange that are acquired as incident to acting as a market maker. In addition, the trading desk generally must maintain its market-maker inventory and financial exposure within its market-maker inventory limit and its financial exposure limit, respectively and, to the extent that any limit of the trading desk is exceeded, the trading desk must take action to bring the trading desk into compliance with the limits as promptly as possible after the limit is exceeded.713 Thus, if market movements cause
a trading desk’s financial exposure to exceed one or more of its risk limits, the trading desk must promptly take action to reduce its financial exposure or obtain approval for an increase to its limits through the required escalation procedures, detailed below. A trading desk may not, however, enter into a trade that would cause it to exceed its limits without first receiving approval through its escalation procedures.714 Under the final rule, the term marketmaker inventory is defined to mean all of the positions, in the financial instruments for which the trading desk stands ready to make a market in accordance with paragraph (b)(2)(i) of this section, that are managed by the trading desk, including the trading desk’s open positions or exposures arising from open transactions.715 Those financial instruments in which a trading desk acts as market maker must be identified in the trading desk’s compliance program under §ll .4(b)(2)(iii)(A) of the final rule. As used throughout this SUPPLEMENTARY INFORMATION, the term ‘‘inventory’’ refers to both the retention of financial instruments (e.g., securities) and, in the context of derivatives trading, the risk exposures arising out of market-making related activities.716 Consistent with the statute, the final rule requires that the market-maker inventory of a trading desk be designed not to exceed, on an ongoing basis, the reasonably expected near term demands of clients, customers, or counterparties. The financial exposure concept is broader in scope than market-maker inventory and reflects the aggregate risks of the financial instruments (as well as any associated loans, spot commodities, or spot foreign exchange or currency) the trading desk manages as part of its market making-related activities.717 Thus, a trading desk’s financial exposure will take into account a trading desk’s positions in instruments for which it does not act as a market maker, but which are established as part of its market makingrelated activities, which includes risk mitigation and hedging. For instance, a trading desk that acts as a market maker in Euro-denominated corporate bonds may, in addition to Euro-denominated bonds, enter into credit default swap transactions on individual European corporate bond issuers or an index of European corporate bond issuers in order to hedge its exposure arising from its corporate bond inventory, in accordance with its documented hedging policies and procedures. Though only the corporate bonds would be considered as part of the trading desk’s market-maker inventory, its overall financial exposure would also include the credit default swaps used for hedging purposes. As noted above, the Agencies believe the extent to which a trading desk is engaged in permitted market makingrelated activities is best determined by

718See infra Part IV.A.3.c.2.c.; final rule §ll.4(b)(2)(iii)(C). 719See, e.g., SIFMA et al. (Prop. Trading) (Feb.
2012) (stating that modern trading units generally
view individual positions as a bundle of characteristics that contribute to their complete portfolio). See also Federal Reserve Board, Trading and Capital-Markets Activities Manual § 2000.1 (Feb. 1998) (‘‘The risk-measurement system should also permit disaggregation of risk by type and by customer, instrument, or business unit to effectively support the management and control of risks.’’). 720See ACLI (Feb. 2012); Fixed Income Forum/ Credit Roundtable; SIFMA et al. (Prop. Trading) (Feb. 2012). 721See final rule §ll.4(b)(4). 722Final rule §ll.4(b)(4). For example, in the case of derivatives, a trading desk’s financial position will be the residual risks of the trading desk’s open positions. For instance, an options desk may have thousands of open trades at any given time, including hedges, but the desk will manage, among other risk factors, the trading desk’s portfolio delta, gamma, rho, and volatility. evaluating both the financial exposure that results from the desk’s trading activity and the amount, types, and risks of the financial instruments in the desk’s market-maker inventory. Both concepts are independently valuable and will contribute to the effectiveness of the market-making exemption. Specifically, a trading desk’s financial exposure will highlight the net exposure and risks of its positions and, along with an analysis of the actions the trading desk will take to demonstrably reduce or otherwise significantly mitigate promptly the risks of that exposure consistent with its limits, the extent to which it is appropriately managing the risk of its market-maker inventory consistent with applicable limits, all of which are significant to an analysis of whether a trading desk is engaged in market making-related activities. An assessment of the amount, types, and risks of the financial instruments in a trading desk’s market-maker inventory will identify the aggregate amount of the desk’s inventory in financial instruments for which it acts as market maker, the types of these financial instruments that the desk holds at a particular time, and the risks arising from such holdings. Importantly, an analysis of a trading desk’s marketmaker inventory will inform the extent to which this inventory is related to the reasonably expected near term demands of clients, customers, or counterparties. Because the market-maker inventory concept is more directly related to the financial instruments that a trading desk buys and sells from customers than the financial exposure concept, the Agencies believe that requiring review and analysis of a trading desk’s marketmaker inventory, as well as its financial exposure, will enhance compliance with the statute’s near-term customer demand requirement. While the amount, types, and risks of a trading desk’s market-maker inventory are constrained by the near-term customer demand requirement, any other positions in financial instruments managed by the trading desk as part of its market making-related activities
(i.e., those reflected in the trading desk’s financial exposure, but not included in the trading desk’s market-maker inventory) are also constrained because they must be consistent with the market-maker inventory or, if taken for hedging purposes, designed to reduce the risks of the trading desk’s marketmaker inventory. The Agencies note that disaggregating the trading desk’s market-maker inventory from its other exposures also allows for better identification of the trading desk’s hedging positions in instruments for which the trading desk does not make a market. As a result, a banking entity’s systems should be able to readily identify and monitor the trading desk’s hedging positions that are not in its market-maker inventory. As discussed in Part IV.A.3.c.3., a trading desk must have certain inventory and risk limits on its market-maker inventory, the products, instruments, and exposures the trading desk may use for risk management purposes, and its financial exposure that are designed to facilitate the trading desk’s compliance with the exemption and that are based on the nature and amount of the trading desk’s market making-related activities, including analyses regarding the reasonably expected near term demands of customers.718 The final rule also requires these policies and procedures to contain escalation procedures if a trade would exceed the limits set for the trading desk. However, the final rule does not permit a trading desk to exceed the limits solely based on customer demand. Rather, before executing a trade that would exceed the desk’s limits or changing the desk’s limits, a trading desk must first follow the relevant escalation procedures, which may require additional approval within the banking entity and provide demonstrable analysis that the basis for any temporary or permanent increase in limits is consistent with the reasonably expected near term demands of customers. Due to these considerations, the Agencies believe the final rule should result in more efficient compliance analyses on the part of both banking entities and Agency supervisors and examiners and should be less costly for banking entities to implement than a transaction-by-transaction or instrument-by-instrument approach. For example, the Agencies believe that some banking entities already compute and monitor most trading desks’ financial exposures for risk management or other purposes.719 The Agencies also believe that focusing on the financial exposure and market-maker inventory of a trading desk, as opposed to each separate individual transaction, is consistent with the statute’s goal of reducing proprietary trading risk in the banking system and its exemption for market making-related activities. The Agencies recognize that banking entities may not currently disaggregate trading desks’ market-maker inventory from their financial exposures and that, to the extent banking entities do not currently separately identify trading desks’ market-maker inventory,
requiring such disaggregation for purposes of this rule will impose certain costs. In addition, the Agencies understand that an approach focused solely on the aggregate of all the unit’s trading positions, as suggested by some commenters, would present fewer burdens.720 However, for the reasons discussed above, the Agencies believe such disaggregation is necessary to give full effect to the statute’s near term customer demand requirement. The Agencies note that whether a financial instrument or exposure stemming from a derivative is considered to be market-maker inventory is based only on whether the desk makes a market in the financial instrument, regardless of the type of counterparty or the purpose of the transaction. Thus, the Agencies believe that banking entities should be able to develop a standardized methodology for identifying a trading desk’s positions and exposures in the financial instruments for which it acts as a market maker. As further discussed in this Part, a trading desk’s financial exposure must reflect the aggregate risks managed by the trading desk as part of its market making-related activities,721 and a banking entity should be able to demonstrate that the financial exposure of a trading desk is related to its marketmaking activities. The final rule defines ‘‘financial exposure’’ to mean the ‘‘aggregate risks of one or more financial instruments and any associated loans, commodities, or foreign exchange or currency, held by a banking entity or its affiliate and managed by a particular trading desk as
part of the trading desk’s market
making-related activities.’’ 722 In this context, the term ‘‘aggregate’’ does not imply that a long exposure in one instrument can be combined with a short exposure in a similar or related

723As discussed in Part IV.A.3.c.3., a banking entity must establish, implement, maintain, and enforce policies and procedures, internal controls, analysis, and independent testing regarding the financial instruments each trading desk stands ready to purchase and sell and the products, instruments, or exposures each trading desk may use for risk management purposes. See final rule §ll.4(b)(2)(iii). 724Other statutory or regulatory requirements, including those based on prudential safety and soundness concerns, may prevent or limit a banking entity from booking hedging positions in a legal entity other than the entity taking the underlying position. 725See infra Part IV.A.3.c.4. 726Under these circumstances, the other organizational unit would also be required to meet the hedging exemption’s documentation requirement for the risk-mitigating transaction. See final rule §ll.5(c). 727A banking entity must be able to provide such records when a related position is held at an affiliate, even if the affiliate and the banking entity are not subject to the same Agency’s regulatory jurisdiction. instrument to yield a total exposure of zero. Instead, such a combination may reduce a trading desk’s economic exposure to certain risk factors that are common to both instruments, but it would still retain any basis risk between those financial instruments or potentially generate a new risk exposure in the case of purposeful hedging. With respect to the frequency with which a trading desk should determine its financial exposure and the amount, types, and risks of the financial instruments in its market-maker inventory, a trading desk’s financial exposure and market-maker inventory should be evaluated and monitored at a frequency that is appropriate for the trading desk’s trading strategies and the characteristics of the financial instruments the desk trades, including historical intraday volatility. For example, a trading desk that repeatedly acquired and then terminated significant financial exposures throughout the day but that had little or no financial exposure at the end of the day should assess its financial exposure based on its intraday activities, not simply its end-of-day financial exposure. The frequency with which a trading desk’s financial exposure and market-maker inventory will be monitored and analyzed should be specified in the trading desk’s compliance program. A trading desk’s financial exposure reflects its aggregate risk exposures. The types of ‘‘aggregate risks’’ identified in the trading desk’s financial exposure should reflect consideration of all significant market factors relevant to the financial instruments in which the trading desk acts as market maker or that the desk uses for risk management purposes pursuant to this exemption, including the liquidity, maturity, and depth of the market for the relevant types of financial instruments. Thus, market factors reflected in a trading desk’s financial exposure should include all significant
and relevant factors associated with the products and instruments in which the desk trades as market maker or for risk management purposes, including basis risk arising from such positions.723 Similarly, an assessment of the risks of the trading desk’s market-maker inventory must reflect consideration of all significant market factors relevant to the financial instruments in which the trading desk makes a market. Importantly, a trading desk’s financial exposure and the risks of its market-maker inventory will change based on the desk’s trading activity (e.g., buying an instrument that it did not previously hold, increasing its position in an instrument, or decreasing its position in an instrument) as well as changing market conditions related to instruments or positions managed by the trading desk. Because the final rule defines ‘‘trading desk’’ based on operational functionality rather than corporate formality, a trading desk’s financial exposure may include positions that are booked in different affiliated legal entities.724 The Agencies understand that positions may be booked in different legal entities for a variety of reasons, including regulatory reasons. For example, a trading desk that makes a market in corporate bonds may book its corporate bond positions in an SECregistered broker-dealer and may book index CDS positions acquired for hedging purposes in a CFTC-registered swap dealer. A financial exposure that reflects both the corporate bond position and the index CDS position better reflects the economic reality of the trading desk’s risk exposure (i.e., by showing that the risk of the corporate bond position has been reduced by the index CDS position). In addition, a trading desk engaged in market making-related activities in compliance with the final rule may direct another organizational unit of the banking entity or an affiliate to execute a risk-mitigating transaction on the trading desk’s behalf.725 The other organizational unit may rely on the market-making exemption for these purposes only if: (i) The other organizational unit acts in accordance with the trading desk’s risk management policies and procedures established in accordance with § ll.4(b)(2)(iii) of the final rule; and (ii) the resulting riskmitigating position is attributed to the trading desk’s financial exposure (and not the other organizational unit’s financial exposure) and is included in the trading desk’s daily profit and loss calculation. If another organizational unit of the banking entity or an affiliate establishes a risk-mitigating position for the trading desk on its own accord (i.e., not at the direction of the trading desk) or if the risk-mitigating position is included in the other organizational unit’s financial exposure or daily profit and loss calculation, then the other organizational unit must comply with the requirements of the hedging exemption for such activity.726 It may not rely on the market-making exemption under these circumstances. If a
trading desk engages in a riskmitigating transaction with a second trading desk of the banking entity or an affiliate that is also engaged in permissible market making-related activities, then the risk-mitigating position would be included in the first trading desk’s financial exposure and the contra-risk would be included in the second trading desk’s market-maker inventory and financial exposure. The Agencies believe the net effect of the final rule is to allow individual trading desks to efficiently manage their own hedging and risk mitigation activities on a holistic basis, while only allowing for external hedging directed by staff outside of the trading desk under the additional requirements of the hedging exemption. To include in a trading desk’s financial exposure either positions held at an affiliated legal entity or positions established by another organizational unit on the trading desk’s behalf, a banking entity must be able to provide supervisors or examiners of any Agency that has regulatory authority over the banking entity pursuant to section 13(b)(2)(B) of the BHC Act with records, promptly upon request, that identify any related positions held at an affiliated entity that are being included in the trading desk’s financial exposure for purposes of the market-making exemption. Similarly, the supervisors and examiners of any Agency that has supervisory authority over the banking entity that holds financial instruments that are being included in another trading desk’s financial exposure for purposes of the market-making exemption must have the same level of access to the records of the trading desk.727 Banking entities should be prepared to provide all records that identify all positions included in a trading desk’s financial exposure and where such positions are held.

728The Agencies believe it is appropriate to apply the requirements of the exemption to the financial exposure of a ‘‘trading desk,’’ rather than the portfolio of a higher level of organization, for the reasons discussed above, including our concern that aggregating a large number of disparate positions and exposures across a range of trading desks could increase the risk of evasion. See supra Part IV.A.3.c.1.c.i. (discussing the determination to apply requirements at the trading desk level). 729See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012). 730See, e.g., Occupy. 731 Indeed, in the most specialized situations, such quotations may only be provided upon request. See infra note 735 and accompanying text (discussing permissible block positioning). 732The Agencies will consider factors similar to those identified by the CFTC and SEC in connection with this standard. See Further Definition of ‘‘Swap Dealer,’’ ‘‘Security-Based Swap Dealer,’’ ‘‘Major Swap Participant,’’ ‘‘Major Security-Based Swap Participant’’ and ‘‘Eligible Contract Participant’’, 77 FR 30596, 30609 (May 23, 2012) As an example of how a trading desk’s market-maker inventory and financial exposure will be analyzed under the market-making exemption, assume a trading desk makes a market in a variety of U.S. corporate bonds and hedges its aggregated positions with a combination of exposures to corporate bond indexes and specific name CDS in which the desk does not make a market. To qualify for the market-making exemption, the trading desk would have to demonstrate, among other things, that:
(i) The desk routinely stands ready to purchase and sell the U.S. corporate bonds, consistent with the requirement of §ll.4(b)(2)(i) of the final rule, and these instruments (or category of instruments) are identified in the trading desk’s compliance program; (ii) the trading desk’s market-maker inventory in U.S. corporate bonds is designed not to exceed, on an ongoing basis, the reasonably expected near term demands of clients, customers, or counterparties, consistent with the analysis and limits established by the banking entity for the trading desk; (iii) the trading desk’s exposures to corporate bond indexes and single name CDS are designed to mitigate the risk of its financial exposure, are consistent with the products, instruments, or exposures and the techniques and strategies that the trading desk may use to manage its risk effectively (and such use continues to be effective), and do not exceed the trading desk’s limits on the amount, types, and risks of the products, instruments, and exposures the trading desk uses for risk management purposes; and (iv) the aggregate risks of the trading desk’s exposures to U.S. corporate bonds, corporate bond indexes, and single name CDS do not exceed the trading desk’s limits on the level of exposures to relevant risk factors arising from its financial exposure. Our focus on the financial exposure of a trading desk, rather than a trade-bytrade requirement, is designed to give banking entities the flexibility to acquire not only market-maker inventory, but positions that facilitate market making, such as positions that hedge marketmaker inventory.728 As commenters pointed out, a trade-by-trade requirement would view trades in isolation and could fail to recognize that certain trades that are not customerfacing are nevertheless integral to market making and financial intermediation.729 The Agencies understand that the risk-reducing effects of combining large diverse portfolios could, in certain instances, mask otherwise prohibited proprietary trading.730 However, the Agencies do not believe that taking a transaction-bytransaction approach is necessary to address this concern. Rather, the Agencies believe that the broader definitions of ‘‘financial exposure’’ and ‘‘market-maker inventory’’ coupled with the tailored definition of ‘‘trading desk’’ facilitates the analysis of aggregate risk exposures and positions in a manner best suited to apply and evaluate the market-making exemption. In short, this approach is designed to mitigate the costs of a trade-by-trade analysis identified by commenters. The Agencies recognize, however, that this approach is only effective at achieving the goals of the section 13 of the BHC Act—promoting financial intermediation and limiting speculative risks within banking entities—if there are limits on a trading desk’s financial exposure. That is, a permissive marketmaking exemption that gives banking entities maximum discretion in acquiring positions to provide liquidity
runs the risk of also allowing banking entities to engage in speculative trades. As discussed more fully in the following Parts of this SUPPLEMENTARY INFORMATION, the final market-making exemption provides a number of controls on a trading desk’s financial exposure. These controls include, among others, a provision requiring that a trading desk’s market-maker inventory be designed not to exceed, on an ongoing basis, the reasonably expected near term demands of customers and that any other financial instruments managed by the trading desk be designed to mitigate the risk of such desk’s market-maker inventory. In addition, the final market-making exemption requires the trading desk’s compliance program to include appropriate risk and inventory limits tied to the near term demand requirement, as well as escalation procedures if a trade would exceed such limits. The compliance program, which includes internal controls and independent testing, is designed to prevent instances where transactions not related to providing financial intermediation services are part of a desk’s financial exposure.
iii. Routinely Standing Ready To Buy
and Sell
The requirement to routinely stand ready to buy and sell a type of financial instrument in the final rule recognizes that market making-related activities differ based on the liquidity, maturity, and depth of the market for the relevant type of financial instrument. For example, a trading desk acting as a market maker in highly liquid markets would engage in more regular quoting activity than a market maker in less liquid markets. Moreover, the Agencies recognize that the maturity and depth of the market also play a role in determining the character of a market maker’s activity. As noted above, the standard of ‘‘routinely’’ standing ready to buy and sell will differ across markets and asset classes based on the liquidity, maturity, and depth of the market for the type of financial instrument. For instance, a trading desk that is a market maker in liquid equity securities generally should engage in very regular or continuous quoting and trading activities on both sides of the market. In less liquid markets, a trading desk should engage in regular quoting activity across the relevant type(s) of financial instruments, although such quoting may be less frequent than in liquid equity markets.731 Consistent with the CFTC’s and SEC’s interpretation of market making in swaps and security-based swaps for purposes of the definitions of ‘‘swap dealer’’ and ‘‘security-based swap dealer,’’ ‘‘routinely’’ in the swap market context means that the trading desk should stand ready to enter into swaps or security-based swaps at the request or demand of a counterparty more frequently than occasionally.732 The Agencies note that a trading desk may routinely stand ready to enter into derivatives on both sides of the market, or it may routinely stand ready to enter into derivatives on either side of the market and then enter into one or more offsetting positions in the derivatives market or another market, particularly in the case of relatively less liquid derivatives. While a trading desk may respond to requests to trade certain

733The Agencies recognize that, as noted by commenters, preventing a banking entity from conducting customized transactions with customers may impact customers’ risk exposures or transaction costs. See Goldman (Prop. Trading); SIFMA (Asset Mgmt.) (Feb. 2012). The Agencies are not prohibiting this activity under the final rule, as discussed in this Part. 734The Agencies have considered comments on the issue of whether trading by appointment should be permitted under the final market-making exemption. The Agencies believe it is appropriate to permit trading by appointment to the extent that there is customer demand for liquidity in the relevant products. 735As noted in the preamble to the proposed rule, the size of a block will vary among different asset classes. The Agencies also stated in the proposal that the SEC’s definition of ‘‘qualified block positioner’’ in Rule 3b–8(c) under the Exchange Act may serve as guidance for determining whether block positioning activity qualifies for the marketmaking exemption. In referencing that rule as guidance, the Agencies did not intend to imply that a banking entity engaged in block positioning activity would be required to meet all terms of the ‘‘qualified block positioner’’ definition at all times. Nonetheless, a number of commenters indicated that it was unclear when a banking entity would need to act as a qualified block positioner in accordance with Rule 3b–8(c) and expressed concern that uncertainty could have a chilling effect on a banking entity’s willingness to facilitate customer block trades. See, e.g., RBC; SIFMA (Asset Mgmt.) (Feb. 2012); Goldman (Prop. Trading). For example, a few commenters stated that certain requirements in Rule 3b–8(c) could cause fire sales or general market uncertainty. See id. After considering comments, the Agencies have decided that the reference to Rule 3b–8(c) is unnecessary for purposes of the final rule. In particular, the Agencies believe that the requirements in the market-making exemption provide sufficient safeguards, and the additional requirements of the ‘‘qualified block positioner’’ definition may present unnecessary burdens or redundancies with the rule, as adopted. For example, the Agencies believe that there is some overlap between §ll.4(b)(2)(ii) of the exemption, which provides that the amount, types, and risks of the financial instruments in the trading desk’s market-maker inventory must be designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties, and Rule 3b–8(c)(iii), which requires the sale of the shares comprising the block as rapidly as possible commensurate with the circumstances. In other words, the market-making exemption would require a banking entity to appropriately manage its inventory when engaged in block positioning activity, but would not speak directly to the timing element given the diversity of markets to which the exemption applies. As noted above, one commenter analyzed the
potential market impact of a complete restriction on a market maker’s ability to provide direct liquidity to help a customer execute a large block trade. See supra note 682 and accompanying text. Because the Agencies are not restricting a banking entity’s ability to engage in block positioning in the manner suggested by this commenter, the Agencies do not believe that the final rule will cause the cited market impact of incremental transaction costs between $1.7 and $3.4 billion per year. The Agencies address this commenter’s concern about the impact of inventory metrics on a banking entity’s willingness to engage in block trading in
Part IV.C.3. (discussing the metrics requirement in
the final rule and noting that metrics will not be used to determine compliance with the rule but, rather, will be monitored for patterns over time to identify activities that may warrant further review). One commenter appeared to request that block trading activity not be subject to all requirements of the market-making exemption. See SIFMA (Asset Mgmt.) (Feb. 2012). Any activity conducted in reliance on the market-making exemption, including block trading activity, must meet the requirements of the market-making exemption. The Agencies believe the requirements in the final rule are workable for block positioning activity and do not believe it would be appropriate to subject block positioning to lesser requirements than general market-making activity. For example, trading in large block sizes can expose a trading desk to greater risk than market making in smaller sizes, particularly absent risk management requirements. Thus, the Agencies believe it is important for block positioning activity to be subject to the same requirements, including the requirements to establish risk limits and risk management procedures, as general market-making activity. 736This approach is generally consistent with commenters’ requested clarification that a trading desk’s quoting activity will not be assessed on an instrument-by-instrument basis, but rather across a range of similar instruments for which the trading desk acts as a market maker. See, e.g., RBC; SIFMA et al. (Prop. Trading) (Feb. 2012); CIEBA; Goldman (Prop. Trading). 737See, e.g., Goldman (Prop. Trading); Morgan Stanley; RBC; SIFMA et al. (Prop. Trading) (Feb. 2012). 738The Agencies recognize that there could be limited circumstances under which a trading desk’s financial exposure does not relate to the types of financial instruments that it is standing ready to buy and sell for a short period of time. However, the Agencies would expect for such occurrences to be minimal. For example, this scenario could occur if a trading desk unwinds a hedge position after the market-making position has already been unwound or if a trading desk acquires an anticipatory hedge position prior to acquiring a market-making position. As discussed more thoroughly in Part IV.A.3.c.3., a banking entity must establish written policies and procedures, internal controls, analysis, and independent testing that establish appropriate parameters around such activities. products, such as custom swaps, even if it does not normally quote in the particular product, the trading desk should hedge against the resulting exposure in accordance with its financial exposure and hedging limits.733 Further, the Agencies continue to recognize that market makers in highly illiquid markets may trade only intermittently or at the request of particular customers, which is sometimes referred to as trading by appointment.734 A trading desk’s block positioning activity would also meet the terms of this requirement provided that, from time to time, the
desk engages in block trades (i.e., trades of a large quantity or with a high dollar value) with customers.735 Regardless of the liquidity, maturity, and depth of the market for a particular type of financial instrument, a trading desk should have a pattern of providing price indications on either side of the market and a pattern of trading with customers on each side of the market. In particular, in the case of relatively illiquid derivatives or structured instruments, it would not be sufficient to demonstrate that a trading desk on occasion creates a customized instrument or provides a price quote in response to a customer request. Instead, the trading desk would need to be able to demonstrate a pattern of taking these actions in response to demand from multiple customers with respect to both long and short risk exposures in identified types of instruments. This requirement of the final rule applies to a trading desk’s activity in one or more ‘‘types’’ of financial instruments.736 The Agencies recognize that, in some markets, such as the corporate bond market, a market maker may regularly quote a subset of instruments (generally the more liquid instruments), but may not provide regular quotes in other related but less liquid instruments that the market maker is willing and available to trade. Instead, the market maker would provide a price for those instruments upon request.737 The trading desk’s activity, in the aggregate for a particular type of financial instrument, indicates whether it is engaged in activity that is consistent with § ll.4(b)(2)(i) of the final rule. Notably, this requirement provides that the types of financial instruments for which the trading desk routinely stands ready to purchase and sell must be related to its authorized marketmaker inventory and it authorized financial exposure. Thus, the types of financial instruments for which the desk routinely stands ready to buy and sell should compose a significant portion of its overall financial exposure. The only other financial instruments contributing to the trading desk’s overall financial exposure should be those designed to hedge or mitigate the risk of the financial instruments for which the trading desk is making a market. It would not be consistent with the market-making exemption for a trading desk to hold only positions in, or be exposed to, financial instruments for which the trading desk is not a market maker.738 A trading desk’s routine presence in the market for a particular type of financial instrument would not, on its own, be sufficient grounds for relying on the market-making exemption. This is because the frequency at which a trading desk is active in a particular market would not, on its own, distinguish between permitted market making-related activity and impermissible proprietary trading. In response to comments, the final rule provides that a trading desk also must be willing and available to quote, buy and sell, or otherwise enter into long and short
positions in the relevant type(s) of financial instruments for its

739See, e.g., Occupy; Better Markets (Feb. 2012). 740One commenter expressed concern that a banking entity may be able to rely on the marketmaking exemption when it is providing only wide, out of context quotes. See Occupy. 741As discussed below, this may include providing quotes in the interdealer trading market. 742Algorithmic trading strategies that only trade when market factors are favorable to the strategy’s objectives or that otherwise frequently exit the market would not be considered to be standing ready to purchase or sell a type of financial instrument throughout market cycles and, thus, would not qualify for the market-making exemption. The Agencies believe this addresses commenters’ concerns about high-frequency trading activities that are only active in the market when it is believed to be profitable, rather than to facilitate customers. See, e.g., Better Markets (Feb. 2012). The Agencies are not, however, prohibiting all high-frequency trading activities under the final rule or otherwise limiting high-frequency trading by banking entities by imposing a resting period on their orders, as requested by certain commenters. See, e.g., Better Markets (Feb. 2012); Occupy; Public Citizen. 743See final rule §ll.4(b)(2)(iii)(A). 744See final rule §ll.4(b)(2)(ii). 745See final rule §ll.4(b)(2)(iii)(C). 746For example, a few commenters requested that the rule prohibit banking entities from market making in assets classified as Level 3 under FAS
157. See supra note 651 and accompanying text.
The Agencies continue to believe that it would be inappropriate to incorporate accounting standards in the rule because accounting standards could change in the future without consideration of the potential impact on the final rule. See Joint Proposal, 76 FR 68,859 n.101 (explaining why the Agencies declined to incorporate certain accounting standards in the proposed rule); CFTC Proposal, 77 FR 8344 n.107. Further, a few commenters suggested that the exemption should only be available for trading on an organized trading facility. This type of limitation would require significant and widespread market structure changes (with associated systems and infrastructure costs) in a relatively short period of time, as market making in certain assets is primarily or wholly conducted in the OTC market, and organized trading platforms may not currently exist for these assets. The Agencies do not believe that the costs of such market structure changes would be warranted for purposes of this rule. 747As discussed above, a number of commenters expressed concern about the potential market impacts of the perceived restrictions on market making under the proposed rule, particularly with respect to less liquid markets, such as the corporate bond market. See, e.g., Prof. Duffie; Wellington; BlackRock; ICI. 748 Joint Proposal, 76 FR 68,871 (stating that ‘‘bona fide market making-related activity may include taking positions in securities in anticipation of customer demand, so long as any anticipatory buying or selling activity is reasonable and related to clear, demonstrable trading interest of clients, customers, or counterparties’’); CFTC Proposal, 77 FR 8356–8357; See also Morgan Stanley (requesting certain revisions to more closely track the statute); SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); Chamber (Feb. 2012); Comm. on Capital Markets Regulation; SIFMA (Asset Mgmt.) (Feb. 2012). 749See final rule §ll.4(b)(2)(ii); infra Part IV.A.3.c.2.c. 750See BoA; SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); Morgan Stanley; Chamber (Feb. 2012); Comm. on Capital Markets Regulation; SIFMA (Asset Mgmt.) (Feb. 2012). 751For example, some commenters suggested that the final rule allow market makers to make individualized assessments of anticipated customer demand, based on their expertise and experience, and account for differences between liquid and less liquid markets. See Chamber (Feb. 2012); ISDA (Feb. 2012). The final rule allows such assessments, based on historical customer demand and other relevant factors, and recognizes that near term demand may differ based on the liquidity, maturity, and depth of the market for a particular type of financial instrument. See infra Part IV.A.3.c.2.c.iii. 752See proposed rule §ll.4(b)(2)(iii). own account in commercially reasonable amounts and throughout market cycles.739 Importantly, a trading desk would not meet the terms of this requirement if it provides wide quotations relative to
prevailing market conditions and is not engaged in other activity that evidences a willingness or availability to provide intermediation services.740 Under these circumstances, a trading desk would not be standing ready to purchase and sell because it is not genuinely quoting or trading with customers. In the context of this requirement, ‘‘commercially reasonable amounts’’ means that the desk generally must be willing to quote and trade in sizes requested by other market participants.741 For trading desks that engage in block trading, this would include block trades requested by customers, and this language is not meant to restrict a trading desk from acting as a block positioner. Further, a trading desk must act as a market maker on an appropriate basis throughout market cycles and not only when it is most favorable for it to do so.742 For example, a trading desk should be facilitating customer needs in both upward and downward moving markets. As discussed further in Part IV.A.3.c.3., the financial instruments the trading desk stands ready to buy and sell must be identified in the trading desk’s compliance program.743 Certain requirements in the final exemption apply to the amount, types, and risks of these financial instruments that a trading desk can hold in its marketmaker inventory, including the near term customer demand requirement 744 and the need to have certain risk and inventory limits.745 In response to the proposed requirement that a trading desk or other organizational unit hold itself out, some commenters requested that the Agencies limit the availability of the marketmaking exemption to trading in particular asset classes or trading on particular venues (e.g., organized trading platforms). The Agencies are not limiting the availability of the marketmaking exemption in the manner requested by these commenters.746 Provided there is customer demand for liquidity in a type of financial instrument, the Agencies do not believe the availability of the market-making exemption should depend on the liquidity of that type of financial instrument or the ability to trade such instruments on an organized trading platform. The Agencies see no basis in the statutory text for either approach and believe that the likely harms to investors seeking to trade affected instruments (e.g., reduced ability to purchase or sell a particular instrument, potentially higher transaction costs) and market quality (e.g., reduced liquidity) that would arise under such an approach would not be justified,747 particularly in light of the minimal benefits that might result from restricting or eliminating a banking entity’s ability to hold less liquid assets in connection with its market makingrelated activities. The Agencies believe these commenters’ concerns are adequately addressed by the final rule’s requirements in the market-making exemption that are designed to ensure that a trading desk cannot hold risk in excess of what is appropriate to provide
intermediation services designed not to exceed, on an ongoing basis, the reasonably expected near term demands of clients, customers, or counterparties. In response to comments on the proposed interpretation regarding anticipatory position-taking,748 the Agencies note that the near term demand requirement in the final rule addresses when a trading desk may take positions in anticipation of reasonably expected near term customer demand.749 The Agencies believe this approach is generally consistent with the comments the Agencies received on this issue.750 In addition, the Agencies note that modifications to the proposed near term demand requirement in the final rule also address commenters concerns on this issue.751
2. Near Term Customer Demand
Requirement a. Proposed Near Term Customer Demand Requirement Consistent with the statute, the proposed rule required that the trading desk or other organizational unit’s market making-related activities be, with respect to the financial instrument, designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties.752 This requirement is intended to prevent a trading desk from taking a speculative proprietary position that is unrelated to customer needs as part of the desk’s

753See Joint Proposal, 76 FR 68,871; CFTC Proposal, 77 FR 8357. 754See id. 755See Joint Proposal, 76 FR 68,871–68,872; CFTC Proposal, 77 FR 8357. 756See supra Part IV.A.3.c.2.a. 757See, e.g., Sens. Merkley & Levin (Feb. 2012); Flynn & Fusselman; Better Markets (Feb. 2012). 758See Better Markets (Feb. 2012); Sens. Merkley & Levin (Feb. 2012). 759See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Chamber (Feb. 2012); T. Rowe Price; SIFMA (Asset Mgmt.) (Feb. 2012); ACLI (Feb. 2012); MetLife; Comm. on Capital Markets Regulation; CIEBA; Credit Suisse (Seidel); SSgA (Feb. 2012); IAA (stating that the proposed requirement is too subjective and would be difficult to administer in a range of scenarios); Barclays; Prof. Duffie. 760See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); T. Rowe Price; CIEBA; Credit Suisse (Seidel); Barclays; Wellington; MetLife; Chamber (Feb. 2012); RBC; Prof. Duffie; ICI (Feb. 2012); SIFMA (Asset Mgmt.) (Feb. 2012). The Agencies respond to these comments in Part IV.A.3.c.2.c., infra. For a discussion of comments regarding inventory management activity conducted in connection with market making, See Part IV.A.3.c.2.b.vi., infra. 761See, e.g., ACLI (Feb. 2012); MetLife; Comm. on Capital Markets Regulation (noting that a market maker may need to hold significant inventory to accommodate potential block trade requests). Two of these commenters stated that a market maker may provide a worse price or may be unwilling to intermediate a large customer position if the market maker has to determine whether holding such position will meet the near term demand requirement, particularly if the market maker would be required to sell the block position over a short period of time. See ACLI (Feb. 2012); MetLife. These comments are addressed in Part IV.A.3.c.2.c.iii., infra. 762See supra Part IV.A.3.c.2.a. 763See SIFMA et al. (Prop. Trading) (Feb. 2012). Another commenter suggested that the Agencies ‘‘establish clear criteria that reflect appropriate revenue from changes in the bid-ask spread,’’ noting that a legitimate market maker should be both selling and buying in a rising market (or, likewise, in a declining market). Public Citizen. 764See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); BoA; ICI (Feb. 2012); ICI Global; Vanguard; SSgA (Feb. 2012); See also infra Part IV.A.3.c.2.b.viii. (discussing comments on whether arbitrage trading should be permitted under the market-making exemption under certain circumstances). 765See Goldman (Prop. Trading); RBC. One of these commenters agreed, however, that a trading desk that is ‘‘wholly’’ engaged in trading that is unrelated to customer demand should not qualify for the proposed market-making exemption. See Goldman (Prop. Trading). 766See JPMC. 767See Joint Proposal, 76 FR 68,871–68,872; CFTC Proposal, 77 FR 8357. 768See, e.g., NYSE Euronext; SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); purported market
making-related activities.753 In the proposal, the Agencies stated that a banking entity’s expectations of near term customer demand should generally be based on the unique customer base of the banking entity’s specific market-making business lines and the near term demand of those customers based on particular factors, beyond a general expectation of price appreciation. The Agencies further stated that they would not expect the activities of a trading desk or other organizational unit to qualify for the market-making exemption if the trading desk or other organizational unit is engaged wholly or principally in trading that is not in response to, or driven by, customer demands, regardless of whether those activities promote price transparency or liquidity. The proposal stated that, for example, a trading desk or other organizational unit of a banking entity that is engaged wholly or principally in arbitrage trading with non-customers would not meet the terms of the proposed rule’s marketmaking exemption.754 With respect to market making in a security that is executed on an exchange or other organized trading facility, the proposal provided that a market maker’s activities are generally consistent with reasonably expected near term customer demand when such activities involve passively providing liquidity by submitting resting orders that interact with the orders of others in a nondirectional or market-neutral trading strategy and the market maker is registered, if the exchange or organized trading facility registers market makers. Under the proposal, activities on an exchange or other organized trading facility that primarily take liquidity, rather than provide liquidity, would not qualify for the market-making exemption, even if conducted by a registered market maker.755 b. Comments Regarding the Proposed Near Term Customer Demand Requirement As noted above, the proposed near term customer demand requirement would implement language found in the statute’s market-making exemption.756 Some commenters expressed general support for this requirement.757 For example, these commenters emphasized that the proposed near term demand requirement is an important component that restricts disguised position-taking or market making in illiquid markets.758 Several other commenters expressed concern that the proposed requirement is too restrictive 759 because, for example, it may impede a market maker’s ability to build or retain inventory 760 or may impact a market maker’s willingness to engage in block trading.761 Comments on particular aspects of this proposed requirement are discussed below, including the proposed interpretation of this requirement in the proposal, the requirement’s potential impact on market maker inventory, potential differences in this standard across asset classes, whether it is possible to predict near term customer demand, and whether the terms ‘‘client,’’ ‘‘customer,’’ or ‘‘counterparty’’ should be defined for purposes of the
exemption.
i. The Proposed Guidance for
Determining Compliance With the Near Term Customer Demand Requirement As discussed in more detail above, the proposal set forth proposed guidance on how a banking entity may comply with the proposed near term customer demand requirement.762 With respect to the language indicating that a banking entity’s determination of near term customer demand should generally be based on the unique customer base of a specific market-making business line (and not merely an expectation of future price appreciation), one commenter stated that it is unclear how a banking entity would be able to make such determinations in markets where trades occur infrequently and customer demand is hard to predict.763 Several commenters expressed concern about the proposal’s statement that a trading desk or other organizational unit engaged wholly or principally in trading that is not in response to, or driven by, customer demands (e.g., arbitrage trading with non-customers) would not qualify for the exemption, regardless of whether the activities promote price transparency or liquidity.764 In particular, commenters stated that it would be difficult for a market-making business to try to divide its activities that are in response to customer demand (e.g., customer intermediation and hedging) from activities that promote price transparency and liquidity (e.g., interdealer trading to test market depth or arbitrage trading) in order to determine their proportionality.765 Another commenter stated that, as a matter of organizational efficiency, firms will often restrict arbitrage trading strategies to certain specific individual traders within the market-making organization, who may sometimes be referred to as a ‘‘desk,’’ and expressed concern that this would be prohibited under the rule.766 In response to the proposed interpretation regarding market making on an exchange or other organized trading facility (and certain similar language in proposed Appendix B),767 several commenters indicated that the reference to passive submission of resting orders may be too restrictive and provided examples of scenarios where market makers may need to use market or marketable limit orders.768 For

RBC. Comments on proposed Appendix B are discussed further in Part IV.A.3.c.8.b., infra. This issue is addressed in note 939 and its accompanying text, infra. 769Some commenters stated that market makers may need to use market or marketable limit orders to build inventory in anticipation of customer demand or in connection with positioning a block trade for a customer. See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; Goldman (Prop. Trading). Two of these commenters noted that these order types may be needed to dispose of positions taken into inventory as part of market making. See RBC; Goldman (Prop. Trading). 770See NYSE Euronext. 771See Goldman (Prop. Trading). 772See SIFMA et al. (Prop. Trading) (Feb. 2012). 773See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading). 774See NYSE Euronext; SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); Occupy. See also infra notes 940 to 941 and accompanying text (addressing these comments). 775See SIFMA et al. (Prop. Trading) (Feb. 2012) (stating that trading units may currently register as market makers with particular, primary exchanges on which they trade, but will serve in a marketmaking capacity on other trading venues from time to time); Goldman (Prop. Trading) (noting that there are more than 12 exchanges and 40 alternative trading systems currently trading U.S. equities). 776See Occupy. In the alternative, this commenter would require all market making to be performed on an exchange or organized trading facility. See id. 777See NYSE Euronext (recognizing that registration status is not necessarily conclusive of engaging in market making-related activities); SIFMA et al. (Prop. Trading) (Feb. 2012) (stating that to the extent a trading unit is registered on a particular exchange or organized trading facility for any type of financial instrument, all of its activities on that exchange or organized trading facility should be presumed to be market making); Goldman (Prop. Trading). See also infra note 940 (responding to these comments). Two commenters noted that certain exchange rules may require market makers to deal for their own account under certain circumstances in order to maintain fair and orderly markets. See NYSE Euronext (discussing NYSE rules); Goldman (Prop. Trading) (discussing NYSE and CBOE rules). For example, according to these commenters, NYSE Rule 104(f)(ii) requires a market maker to maintain fair and orderly markets, which may involve dealing for their own account when there is a lack of price continuity, lack of depth, or if a disparity between supply and demand exists or is reasonably anticipated. See id. 778See Goldman (Prop. Trading). This commenter further stated that trading activities of exchange market makers may be particularly difficult to evaluate with customer-facing metrics (because ‘‘specialist’’ market makers may not have ‘‘customers’’), so conferring a positive presumption of compliance on such market makers would ensure that they can
continue to contribute to liquidity, which benefits customers. This commenter noted that, for example, NYSE designated market makers (‘‘DMMs’’) are generally prohibited from dealing with customers and companies must ‘‘wall off’’ any trading units that act as DMMs. See id. (citing NYSE Rule 98). 779See id. (stating that spread-related metrics, such as Spread Profit and Loss, may be useful for this purpose). 780See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); T. Rowe Price; CIEBA; Credit Suisse (Seidel); Barclays; Wellington; MetLife; Chamber (Feb. 2012); RBC; Prof. Duffie; ICI (Feb. 2012); SIFMA (Asset Mgmt.) (Feb. 2012). These concerns are addressed in Part IV.A.3.c.2.c., infra. 781See, e.g., SIFMA (Asset Mgmt.) (Feb. 2012); T. Rowe Price; CIEBA; ICI (Feb. 2012); RBC. 782See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Chamber (Feb. 2012). 783See Prof. Duffie. However, another commenter stated that a legitimate market maker should respond to customer demand rather than initiate transactions, which is indicative of prohibited proprietary trading. See Public Citizen. 784See Credit Suisse (Seidel) (suggesting that the rule allow market makers to build inventory in products where they believe customer demand will exist, regardless of whether the inventory can be tied to a particular customer in the near term or to historical trends in customer demand); Barclays (recommending the rule require that ‘‘the market making-related activity is conducted by each trading unit such that its activities (including the maintenance of inventory) are designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties consistent with the market and trading patterns of the relevant product, and consistent with the reasonable judgment of the banking entity where such demand cannot be determined with reasonable accuracy’’); CIEBA. In addition, some commenters suggested an interpretation that would provide greater discretion to market makers to enter into trades based on factors such as experience and expertise dealing in the market and market exigencies. See SIFMA et al. (Prop. Trading) (Feb. 2012); Chamber (Feb. 2012). Two commenters suggested that the proposed requirement should be interpreted to permit market-making activity as it currently exists. See Continued example, many of these commenters stated that market makers may need to enter market or marketable limit orders to: (i) build or reduce inventory; 769 (ii) address order imbalances on an exchange by, for example, using market orders to lessen volatility and restore pricing equilibrium; (iii) hedge marketmaking positions; (iv) create markets; 770 (v) test the depth of the markets; (vi) ensure that ETFs, American depositary receipts (‘‘ADRs’’), options, and other instruments remain appropriately priced; 771 and (vii) respond to movements in prices in the markets.772 Two commenters noted that distinctions between limit and market or marketable limit orders may not
be workable in the international context, where exchanges may not use the same order types as U.S. trading facilities.773 A few commenters also addressed the proposed use of a market maker’s exchange registration status as part of the analysis.774 Two commenters stated that the proposed rule should not require a market maker to be registered with an exchange to qualify for the proposed market-making exemption. According to these commenters, there are a large number of exchanges and organized trading facilities on which market makers may need to trade to maintain liquidity across the markets and to provide customers with favorable prices. These commenters indicated that any restrictions or burdens on such trading may decrease liquidity or make it harder to provide customers with the best price for their trade.775 One commenter, however, stated that the exchange registration requirement is reasonable and further supported adding a requirement that traders demonstrate adherence to the same or commensurate standards in markets where registration is not possible.776 Some commenters recommended certain modifications to the proposed analysis. For example, a few commenters requested that the rule presume that a trading unit is engaged in permitted market making-related activity if it is registered as a market maker on a particular exchange or organized trading facility.777 In support of this recommendation, one commenter represented that it would be warranted because registered market makers directly contribute to maintaining liquid and orderly markets and are subject to extensive regulatory requirements in that capacity.778 Another commenter suggested that the Agencies instead use metrics to compare, in the aggregate and over time, the liquidity that a market maker makes rather than takes as part of a broader consideration of the marketmaking character of the relevant trading activity.779
ii. Potential Inventory Restrictions and
Differences Across Asset Classes A number of commenters expressed concern that the proposed requirement may unduly restrict a market maker’s ability to manage its inventory.780 Several of these commenters stated that limitations on inventory would be especially problematic for market making in less liquid markets, like the fixed-income market, where customer demand is more intermittent and positions may need to be held for a longer period of time.781 Some commenters stated that the Agencies’ proposed interpretation of this requirement would restrict a market maker’s inventory in a manner that is inconsistent with the statute. These commenters indicated that the ‘‘designed’’ and ‘‘reasonably expected’’ language of the statute seem to recognize that market makers must anticipate customer requests and accumulate sufficient inventory to meet those reasonably expected demands.782 In addition, one commenter represented that a market maker must have wide latitude and incentives for initiating trades, rather than merely reacting to customer requests for quotes, to properly risk manage its positions or to prepare for anticipated customer demand or supply.783 Many commenters requested certain modifications to the proposed requirement to limit its impact on market maker inventory.784

MetLife; ACLI (Feb. 2012). One commenter requested that the proposed requirement be moved to Appendix B of the rule to provide greater flexibility to consider facts and circumstances of a particular activity. See JPMC. 785See CIEBA; Morgan Stanley; RBC; ICI (Feb. 2012); ISDA (Feb. 2012); Comm. on Capital Markets Regulation; Alfred Brock. The Agencies respond to these comments in Part IV.A.3.c.2.c.ii., infra. 786See ICI (Feb. 2012); CIEBA (stating that, absent a different interpretation for illiquid instruments, market makers will err on the side of holding less inventory to avoid sanctions for violating the rule); RBC. 787See Morgan Stanley. 788See Wellington; MetLife; SIFMA et al. (Prop. Trading) (Feb. 2012); Sens. Merkley & Levin (Feb. 2012); Chamber (Feb. 2012); FTN; RBC; Alfred Brock. These comments are addressed in Part IV.A.3.c.2.c.iii., infra. 789See Sens. Merkley & Levin (Feb. 2012); FTN. 790See FTN. The commenter further indicated that errors in estimating customer demand are managed through kick-out rules and oversight by risk managers and committees, with latitude in decisions being closely related to expected or empirical costs of hedging positions until they result in trading with counterparties. See id. 791See Sens. Merkley & Levin (Feb. 2012) (stating that banking entities should be required to collect inventory data, evaluate the data, develop policies on how to handle particular positions, and make regular adjustments to ensure a turnover of assets commensurate with near term demand of customers). This commenter also suggested that the rule specify the types of inventory metrics that should be collected and suggested that the rate of inventory turnover would be helpful. See id. 792See MetLife; Chamber (Feb. 2012); RBC; CIEBA; Wellington; ICI (Feb. 2012); Alfred Brock. This issue is addressed in Part IV.A.3.c.2.c.iii., infra. 793See ICI (Feb. 2012); CIEBA; RBC; Wellington; Invesco. 794See CIEBA. 795See Joint Proposal, 76 FR 68,960; CFTC Proposal, 77 FR 8439. More specifically, Appendix B stated: ‘‘In the context of market making in a security that is executed on an organized trading facility or an exchange, a ‘customer’ is any person on behalf of whom a buy or sell order has been submitted by a broker-dealer or any other market participant. In the context of market making in a [financial instrument] in an OTC market, a ‘customer’ generally would be a market participant that makes use of the market maker’s intermediation services, either by requesting such services or entering into a continuing relationship with the market maker with respect to such services.’’ Id. On this last point, the proposal elaborated that in certain cases, depending on the conventions of the relevant market (e.g., the OTC derivatives market), such a ‘‘customer’’ may consider itself or refer to itself more generally as a ‘‘counterparty.’’ See Joint Proposal, 76 FR 68,960 n.2; CFTC Proposal, 77 FR 8439 n.2. 796See Joint Proposal, 76 FR 68,874; CFTC Proposal,
77 FR 8359. In particular, Question 99 states: ‘‘Should the terms ‘client,’ ‘customer,’ or ‘counterparty’ be defined for purposes of the market making exemption? If so, how should these terms be defined? For example, would an appropriate definition of ‘customer’ be: (i) A continuing relationship in which the banking entity provides one or more financial products or services prior to the time of the transaction; (ii) a direct and substantive relationship between the banking entity and a prospective customer prior to the transaction; (iii) a relationship initiated by the banking entity to a prospective customer to induce transactions; or (iv) a relationship initiated by the prospective customer with a view to engaging in transactions?’’ Id. 797Comments on this issue are addressed in Part IV.A.3.c.2.c.i., infra. 798See SIFMA et al. (Prop. Trading) (Feb. 2012). See also Credit Suisse (Seidel); RBC (requesting that the Agencies recognize ‘‘wholesale’’ market making as permissible and representing that ‘‘[i]t is irrelevant to an investor whether market liquidity is provided by a broker-dealer with whom the investor maintains a customer account, or whether that broker-dealer looks to another dealer for market liquidity’’). 799See Comm. on Capital Markets Regulation. 800See FTN; ISDA (Feb. 2012); Alfred Brock. Commenters’ views on the importance of permitting inventory management activity in connection with market making are discussed below in Part IV.A.3.c.2.b.vi. Several commenters requested that the Agencies recognize that near term customer demand may vary across different markets and asset classes and implement this requirement flexibly.785 In particular, many of these commenters emphasized that the concept of ‘‘near term demand’’ should be different for less liquid markets, where transactions may occur infrequently, and for liquid markets, where transactions occur more often.786 One commenter requested that the Agencies add the phrase ‘‘based on the characteristics of the relevant market and asset class’’ to the end of the requirement to explicitly acknowledge these differences.787
iii. Predicting Near Term Customer
Demand
Commenters provided views on whether and, if so how, a banking entity may be able to predict near term customer demand for purposes of the proposed requirement.788 For example, two commenters suggested ways in which a banking entity could predict near term customer demand.789 One of these commenters indicated that banking entities should be able to utilize current risk management tools to predict near term customer demand, although these tools may need to be adapted to comply with the rule’s requirements. According to this commenter, dealers commonly assess the following factors across product lines, which can relate to expected customer demand: (i) Recent volumes and customer trends; (ii) trading patterns of specific customers; (iii) analysis of whether the firm has an ability to win new customer business; (iv) comparison of the current market conditions to prior similar periods; (v) liquidity of large investors; and (vi) the
schedule of maturities in customers’
existing positions.790 Another commenter stated that the reasonableness of a market maker’s inventory can be measured by looking to the specifics of the particular market, the size of the customer base being served, and expected customer demand, which banking entities should be required to take into account in both their inventory practices and policies and their actual inventories. This commenter recommended that the rule permit a banking entity to assume a position under the market-making exemption if it can demonstrate a track record or reasonable expectation that it can dispose of a position in the near term.791 Some commenters, however, emphasized that reasonably expected near term customer demand cannot always be accurately predicted.792 Several of these commenters requested the Agencies clarify that banking entities will not be subject to regulatory sanctions if reasonably anticipated near term customer demand does not materialize.793 One commenter further noted that a banking entity entering a new market, or gaining or losing customers, may need greater flexibility in applying the near term demand requirement because its anticipated demand may fluctuate.794
iv. Potential Definitions of ‘‘Client,’’
‘‘Customer,’’ or ‘‘Counterparty’’
Appendix B of the proposal discussed
the proposed meaning of the term ‘‘customer’’ in the context of permitted market making-related activity.795 In addition, the proposal inquired whether the terms ‘‘client,’’ ‘‘customer,’’ or ‘‘counterparty’’ should be defined in the rule for purposes of the market-making exemption.796 Commenters expressed varying views on the proposed interpretations in the proposal and on whether these terms should be defined in the final rule.797 With respect to the proposed interpretations of the term ‘‘customer’’ in Appendix B, one commenter agreed with the proposed interpretations and expressed the belief that the interpretations will allow interdealer market making where brokers or other dealers act as customers. However, this commenter also requested that the Agencies expressly incorporate providing liquidity to other brokers and dealers into the rule text.798 Another commenter similarly stated that instead of focusing solely on customer demand, the rule should be clarified to reflect that demand can come from other dealers or future customers.799 In response to the proposal’s question about whether the terms ‘‘client,’’ ‘‘customer,’’ and ‘‘counterparty’’ should be further defined, a few commenters stated that that the terms should not be defined in the rule.800 Other

801See Japanese Bankers Ass’n.; Credit Suisse (Seidel); Occupy; AFR et al. (Feb. 2012); Public Citizen. 802See AFR et al. (Feb. 2012); Occupy; Public Citizen. One of these commenters also requested that the Agencies remove the terms ‘‘client’’ and ‘‘counterparty’’ from the proposed near term demand requirement. See Occupy. 803See AFR et al. (Feb. 2012); Occupy; Public Citizen. These commenters stated that other banking entities should never be ‘‘customers’’ under the rule. See id. In addition, one of these commenters would further prevent a banking entity’s employees and covered funds from being ‘‘customers’’ under the rule. See AFR et al. (Feb. 2012). 804See AFR et al. (Feb. 2012) (providing a similar definition for the term ‘‘client’’ as well); Public Citizen. 805See AFR et al. (Feb. 2012); Public Citizen. See also Sens. Merkley & Levin (Feb. 2012) (stating that a banking entity’s activities that involve attempting to sell clients financial instruments that it originated, rather than facilitating a secondary market for client trades in previously existing financial products, should be analyzed under the underwriting exemption, not the market-making exemption; in addition, compiling inventory of financial instruments that the bank originated should be viewed as proprietary trading). 806See AFR et al. (Feb. 2012). 807See Credit Suisse (Seidel) (stating that ‘‘customer’’ should be explicitly defined to include any counterparty to whom a banking entity is providing liquidity); ISDA (Feb. 2012) (recommending that, if the Agencies decide to define these terms, a ‘‘counterparty’’ should be defined as the entity on the other side of a transaction, and the terms ‘‘client’’ and ‘‘customer’’ should not be interpreted to require a relationship beyond the isolated provision of a transaction); Japanese Bankers Ass’n. (requesting that it be clearly noted that interbank participants can be customers for interbank market makers). 808See ISDA (Feb. 2012). This commenter’s primary position was that further definitions are not required and could create additional and unnecessary complexity. See id. 809See, e.g., JPMC; Morgan Stanley; Goldman (Prop. Trading); Chamber (Feb. 2012); MetLife; Credit Suisse (Seidel); BoA; ACLI (Feb. 2012); RBC; AFR et al. (Feb. 2012); ISDA (Feb. 2012); Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012). A few commenters noted that the proposed rule would permit a certain amount of interdealer trading. See, e.g., SIFMA et al. (Prop. Trading) (Feb.
2012) (citing statements in the proposal providing
that a market maker’s ‘‘customers’’ vary depending on the asset class and market in which intermediation services are provided and interpreting such statements as allowing interdealer market making where brokers or other dealers act as ‘‘customers’’ within the proposed construct); Goldman (Prop. Trading) (stating that interdealer trading related to hedging or exiting a customer position would be permitted, but expressing concern that requiring each banking entity to justify each of its interdealer trades as being related to one of its own customers would be burdensome and would reduce the effectiveness of the interdealer market). Commenters’ concerns regarding interdealer trading are addressed in Part IV.A.3.c.2.c.i., infra. 810See infra Part IV.A.3.c.8. 811See, e.g., JPMC; SIFMA et al. (Prop. Trading) (Feb. 2012); Oliver Wyman (Feb. 2012) (recognizing that the proposed rule did not include specific limits on interdealer trading, but expressing concern that explicit or implicit limits could be established by supervisors during or after the conformance period). 812See MetLife; SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; Credit Suisse (Seidel); JPMC; BoA; ACLI (Feb. 2012); AFR et al. (Feb. 2012); ISDA (Feb. 2012); Goldman (Prop. Trading); Oliver Wyman (Feb. 2012). 813See RBC (suggesting that explicitly incorporating liquidity provision to other brokers and dealers in the market-making exemption would be consistent with the statute’s reference to meeting the needs of ‘‘counterparties,’’ in addition to the needs of clients and customers); AFR et al. (Feb.
2012) (recognizing that the ability to manage
inventory through interdealer transactions should be accommodated in the rule, but recommending that this activity be conditioned on a market maker having an appropriate level of inventory after an interdealer transaction); Goldman (Prop. Trading) (representing that the Agencies could evaluate and monitor the amount of interdealer trading that is consistent with a particular trading unit’s market making-related or hedging activity through the customer-facing activity category of metrics); Oliver Wyman (Feb. 2012) (recommending removal or modification of any metrics or principles that would indicate that interdealer trading is not permitted). 814See Prof. Duffie; MetLife; ACLI (Feb. 2012); BDA (Feb. 2012). 815See Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012); MetLife; ACLI (Feb. 2012). See also Thakor Study (stating that, when a market maker provides immediacy to a customer, it relies on being able to unwind its positions at opportune times by trading with other market makers, who may have knowledge about impending orders form their own customers that may induce them to trade with the market maker). 816See MetLife; ACLI (Feb. 2012); Goldman (Prop. Trading); Morgan Stanley; Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012). 817See Goldman (Prop. Trading); Chamber (Feb. 2012). See also Prof. Duffie (stating that a market maker acquiring a position from a customer may wish to rebalance its inventory relatively quickly through the interdealer network, which is often more efficient than requesting immediacy from another customer or waiting for another customer who wants to take the opposite side of the trade). 818See Chamber (Feb. 2012); Goldman (Prop. Trading). 819See Oliver Wyman (Feb. 2012) (basing its finding on data from 2009). This commenter also represented that the natural level of interdealer volume in the U.S. corporate bond market made up 16 percent of total trading volume in 2010. See id. 820See Goldman (Prop. Trading); Morgan Stanley. See also BDA (Feb. 2012) (stating that if dealers in the fixed-income market are not able to trade with other dealers to ‘‘cooperate with each other to provide adequate liquidity to the market as a whole,’’ an essential source of liquidity will be eliminated from the market and existing values of Continued commenters indicated that further definition of these terms would be appropriate.801 Some of these commenters suggested that there should be greater limitations on who can be considered a ‘‘customer’’ under the rule.802 These commenters generally indicated that a ‘‘customer’’ should be a person or institution with whom the banking entity has a continuing, or a direct and substantive, relationship prior to the time of the transaction.803 In the case of a new customer, some of these commenters suggested requiring a relationship initiated by the prospective customer with a view to engaging in transactions.804 A few commenters indicated that a party should not be considered a client, customer, or
counterparty if the banking entity: (i) originates a financial product and then finds a counterparty to take the other side of the transaction; 805 or (ii) engages in transactions driven by algorithmic trading strategies.806 Three commenters requested more permissive definitions of these terms.807 According to one of these commenters, because these terms are listed in the disjunctive in the statute, the broadest term—a ‘‘counterparty’’—should prevail.808
v. Interdealer Trading and Trading for
Price Discovery or To Test Market Depth With respect to interdealer trading, many commenters expressed concern that the proposed rule could be interpreted to restrict a market maker’s ability to engage in interdealer trading.809 As a general matter, commenters attributed these concerns to statements in proposed Appendix B810 or to the Customer-Facing Trade Ratio metric in proposed Appendix A.811 A number of commenters requested that the rule be modified to clearly recognize interdealer trading as a component of permitted market making-related activity 812 and suggested ways in which this could be accomplished (e.g., through a definition of ‘‘customer’’ or ‘‘counterparty’’).813 Commenters emphasized that interdealer trading provides certain market benefits, including increased market liquidity; 814 more efficient matching of customer order flow; 815 greater hedging options to reduce risks; 816 enhanced ability to accumulate inventory for current or near term customer demand, work down concentrated positions arising from a customer trade, or otherwise exit a position acquired from a customer; 817 and general price discovery among dealers.818 Regarding the impact of interdealer trading on a market maker’s ability to intermediate customer needs, one commenter studied the potential impact of interdealer trading limits—in combination with inventory limits—on trading in the U.S. corporate bond market. According to this commenter, if interdealer trading had been prohibited and a market maker’s inventory had been limited to the average daily volume of the market as a whole, 69 percent of customer trades would have been prevented.819 Some commenters stated that a banking entity would be less able or willing to provide marketmaking services to customers if it could not engage in interdealer trading.820

fixed income securities will decline and become volatile, harming both investors who currently hold such positions and issuers, who will experience increased interest costs). 821See Chamber (Feb. 2012); Goldman (Prop. Trading). 822See SIFMA et al. (Prop. Trading) (Feb. 2012); Chamber (Feb. 2012); Goldman (Prop. Trading). One commenter provided the following example of such activity: If Security A and Security B have some price correlation but neither trades regularly, then a trader may execute a trade in Security A for price discovery purposes, using the price of Security A to make an informed bid-ask market to a customer in Security B. See SIFMA et al. (Prop. Trading) (Feb. 2012). 823See Goldman (Prop. Trading); Chamber (Feb.
2012) (stating that this type of trading is necessary
in more illiquid markets); SIFMA et al. (Prop. Trading) (Feb. 2012). 824See Goldman (Prop. Trading). 825See Chamber (Feb. 2012). 826See id. 827See Goldman (Prop. Trading). This commenter represented that market makers often make trades with other dealers to test the depth of the markets at particular price points and to understand where supply and demand exist (although such trading is not conducted exclusively with other dealers). This commenter stated that testing the depth of the market is necessary to provide accurate prices to customers, particularly when customers Seeks to enter trades in amounts larger than the amounts offered by dealers who have sent indications to inter-dealer brokers. See id. 828See id. 829See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Credit Suisse (Seidel); Goldman (Prop. Trading); MFA; RBC. Inventory management is addressed in Part IV.A.3.c.2.c., infra. 830See, e.g., MFA (stating that it is critical for banking entities to continue to be able to maintain sufficient levels of inventory, which is dynamic in nature and requires some degree of flexibility in application); RBC (requesting that the Agencies explicitly acknowledge that, depending on market conditions or the characteristics of a particular security, it may be appropriate or necessary for a firm to maintain inventories over extended periods of time in the course of market making-related activities). 831See, e.g., RBC; NYSE Euronext; Fidelity. These commenters cited a colloquy in the Congressional Record between Senator Bayh and Senator Dodd, in which Senator Bayh stated: ‘‘With respect to [section 13 of the BHC Act], the conference report states that banking entities are not prohibited from purchasing and disposing of securities and other instruments in connection with underwriting or market-making activities, provided that activity does not exceed the reasonably expected near-term demands of clients, customers, or counterparties. I want to clarify this language would allow banks to maintain an appropriate dealer inventory and residual risk positions, which are essential parts of the market-making function. Without that flexibility, market makers would not be able to provide liquidity to markets.’’ 156 Cong. Rec. S5906 (daily ed. July 15, 2010) (statement of Sen. Bayh). 832See, e.g., RBC. 833See Goldman (Prop. Trading). 834See id. 835See MFA. 836See RBC. 837See Goldman (Prop. Trading); BoA. 838See Oliver Wyman (Feb. 2012). As this commenter explained, some mutual funds and ETFs track major equity indices and, when the composition of an index changes (e.g., due to the addition or removal of a security or to rising or falling values of listed shares), an announcement is made and all funds tracking the index need to rebalance their portfolios. According to the commenter, banking entities may need to step in to provide liquidity for rebalances of less liquid indices because trades executed on the open market would substantially affect share prices. The
commenter estimated that if market makers are not able to provide direct liquidity for rebalance trades, investors tracking these indices could potentially pay incremental costs of $600 million to $1.8 billion every year. This commenter identified the proposed inventory metrics in Appendix A as potentially limiting a banking entity’s willingness or ability to facilitate index rebalance trades. See id. Two other commenters also discussed the index rebalancing scenario. See Prof. Duffie; Thakor Study. Index rebalancing is addressed in note 931, infra. 839See Credit Suisse (Seidel). 840See CalPERS; Vanguard. These commenters represented that placing increasing capital requirements on aged inventory would ease the rule’s impact on investor liquidity, allow banking entities to internalize the cost of continuing to hold a position at the expense of its ability to take on new positions, and potentially decrease the possibility of a firm realizing a loss on a position by decreasing the time such position is held. See id. One commenter noted that some banking entities As noted above, a few commenters stated that market makers may use interdealer trading for price discovery purposes.821 Some commenters separately discussed the importance of this activity and requested that, when conducted in connection with marketmaking activity, trading for price discovery be considered permitted market making-related activity under the rule.822 Commenters indicated that price discovery-related trading results in certain market benefits, including enhancing the accuracy of prices for customers,823 increasing price efficiency, preventing market instability,824 improving market liquidity, and reducing overall costs for market participants.825 As a converse, one of these commenters stated that restrictions on such activity could result in market makers setting their prices too high, exposing them to significant risk and causing a reduction of marketmaking activity or widening of spreads to offset the risk.826 One commenter further requested that trading to test market depth likewise be permitted under the market-making exemption.827 This commenter represented that the Agencies would be able to evaluate the extent to which trading for price discovery and market depth are consistent with market making-related activities for a particular market through a combination of customer-facing activity metrics, including the Inventory Risk Turnover metric, and knowledge of a banking entity’s trading business developed by regulators as part of the supervisory process.828
vi. Inventory Management
Several commenters requested that the rule provide banking entities with greater discretion to manage their inventories in connection with market making-related activity, including acquiring or disposing of positions in anticipation of customer demand.829 Commenters represented that market makers need to be able to build, manage, and maintain inventories to facilitate customer demand. These commenters further stated that the rule needs to provide some degree of flexibility for inventory management activities, as inventory needs may differ based on market conditions or the characteristics of a particular instrument.830 A few commenters cited legislative history in support of allowing banking entities to hold and manage inventory in connection with market making-related activities.831 Several commenters noted benefits that are associated with a market maker’s ability to appropriately manage its inventory, including being able to meet reasonably anticipated future client, customer, or counterparty demand; 832 accommodating customer transactions more quickly and at favorable prices; reducing near term price volatility (in the case of selling a customer block position); 833 helping maintain an orderly market and provide the best price to customers (in the case of accumulating long or short positions in anticipation of a large customer sale or purchase); 834 ensuring that markets continue to have sufficient liquidity; 835 fostering a two-way market; and establishing a market-making presence.836 Some commenters noted that market makers may need to accumulate inventory to meet customer demand for certain products or under certain trading scenarios, such as to create units of structured products (e.g., ETFs and asset-backed securities) 837 and in anticipation of an index rebalance.838 Commenters also expressed views with respect to how much discretion a banking entity should have to manage its inventory under the exemption and how to best monitor inventory levels. For example, one commenter recommended that the rule allow market makers to build inventory in products where they believe customer demand will exist, regardless of whether the inventory can be tied to a particular customer in the near term or to historical trends in customer demand.839 A few commenters suggested that the Agencies provide banking entities with greater discretion to accumulate inventory, but discourage market makers from holding inventory for long periods of time by imposing increasingly higher capital requirements on aged inventory.840 One commenter

already use this approach to manage risk on their market-making desks. See Vanguard. See also Capital Group (suggesting that one way to implement the statutory exemption would be to charge a trader or a trading desk for positions held on its balance sheet beyond set time periods and to increase the charge at set intervals). These comments are addressed in note 923, infra. 841See Goldman (Prop. Trading) (representing that the Inventory Risk Turnover metric will allow the Agencies to evaluate the length of time that a trading unit tends to hold risk positions in inventory and whether that holding time is consistent with market making-related activities in the relevant market). 842See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); BoA; ICI (stating that an AP may trade with the ETF issuer in different capacities—in connection with traditional market-making activity, on behalf of customers, or for the AP’s own account); ICI Global (discussing non-U.S. ETFs specifically); Vanguard; SSgA (Feb. 2012). One commenter represented that an AP’s transactions in ETFs do not create risks associated with proprietary trading because, when an AP trades with an ETF issuer for its own account, the AP typically enters into an offsetting transaction in the underlying portfolio of securities, which cancels out investment risk and limits the AP’s exposure to the difference between the market price for ETF shares and the ETF’s net asset value (‘‘NAV’’). See Vanguard. With respect to market-making activity in an ETF, several commenters noted that market makers play an important role in maintaining price alignment by engaging in arbitrage transactions between the ETF shares and the shares of the underlying components. See, e.g., JPMC; Goldman (Prop. Trading) (making similar statement with respect to ADRs as well); SSgA (Feb. 2012); SIFMA et al. (Prop. Trading) (Feb. 2012); Credit Suisse (Seidel); RBC. AP and market maker activity in ETFs are addressed in Part IV.A.3.c.2.c.i., infra. 843See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; ICI (Feb. 2012) ICI Global; Vanguard; SSgA (Feb. 2012). 844See JPMC; Goldman (Prop. Trading); SIFMA et al. (Prop. Trading) (Feb. 2012); SSgA (Feb. 2012); ICI (Feb. 2012) ICI Global. 845See ICI Global; ICI (Feb. 2012) SIFMA et al. (Prop. Trading) (Feb. 2012); BoA. 846See BoA; ICI (Feb. 2012); ICI Global. 847See BoA (stating that lending the ETF shares to an investor gives the investor a more efficient way to hedge its exposure to assets correlated with those underlying the ETF). 848See ICI Global; ICI (Feb. 2012). 849See, e.g., Vanguard (noting that APs may not engage in market-making activity in the ETF and expressing concern that if AP activities are not separately permitted, banking entities may exit or not enter the ETF market); SSgA (Feb. 2012) (stating that APs are under no obligation to make markets in ETF shares and requiring such an obligation would discourage banking entities
from acting as APs); ICI (Feb. 2012). 850See SSgA (Feb. 2012). This commenter further stated that as of 2011, an estimated 3.5 million— or 3 percent—of U.S. households owned ETFs and, as of September 2011, ETFs represented assets of approximately $951 billion. See id. 851See BoA; Vanguard (stating that this determination may be particularly difficult in the case of a new ETF). 852See BoA. This commenter noted that the proposed source of revenue requirement could be interpreted to prevent a banking entity acting as AP from entering into creation and redemption transactions, ‘‘Seeding’’ an ETF, engaging in ‘‘create to lend’’ transactions, and performing secondary market making in an ETF because all of these activities require an AP to build an inventory— either in ETF shares or the underlying components—which often result in revenue attributable to price movements. See id. 853Commenters noted that this language would restrict an AP from engaging in price arbitrage to maintain efficient markets in ETFs. See Vanguard; RBC; Goldman (Prop. Trading); JPMC; SIFMA et al. (Prop. Trading) (Feb. 2012). See supra Part IV.A.3.c.2.a. (discussing the proposal’s proposed interpretation regarding arbitrage trading). 854See BoA; Vanguard (stating that this determination may be particularly difficult in the case of a new ETF). 855See ICI Global; ICI (Feb. 2012). 856See ICI (Feb. 2012) ICI Global. These commenters provided suggested rule text on this issue and suggested that the Agencies could require a banking entity’s compliance policies and internal controls to take a comprehensive approach to the entirety of an AP’s trading activity, which would facilitate easy monitoring of the activity to ensure compliance. See id. 857See Joint Proposal, 76 FR 68,873 (question 91) (inquiring whether the proposed exemption should be modified to permit certain arbitrage trading activities engaged in by market makers that promote liquidity or price transparency but do not service client, customer, or counterparty demand); CFTC Proposal, 77 FR 8359. 858See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); FTN; RBC; ISDA (Feb. 2012). Arbitrage trading is further discussed in Part IV.A.3.c.2.c.i., infra. 859See SIFMA et al. (Prop. Trading) (Feb. 2012). represented that a trading unit’s inventory management practices could be monitored with the Inventory Risk Turnover metric, in conjunction with other metrics.841
vii. Acting as an Authorized Participant
or Market Maker in Exchange-Traded Funds With respect to ETF trading, commenters generally requested clarification that a banking entity can serve as an authorized participant (‘‘AP’’) to an ETF issuer or can engage in ETF market making under the proposed exemption.842 According to commenters, APs may engage in the following types of activities with respect to ETFs: (i) trading directly with the ETF issuer to create or redeem ETF shares, which involves trading in ETF shares and the underlying components; 843 (ii) trading to maintain price alignment between the ETF shares and the underlying components; 844 (iii) traditional market-making activity; 845 (iv) ‘‘seeding’’ a new ETF by entering into several initial creation transactions with an ETF issuer and holding the ETF shares, possibly for an extended period of time, until the ETF establishes regular trading and liquidity in the secondary markets; 846 (v) ‘‘create to lend’’ transactions, where an AP enters a creation transaction with the ETF issuer and lends the ETF shares to an investor; 847 and (vi) hedging.848 A few commenters noted that an AP may not engage in traditional market-making activity in the relevant ETF and expressed concern that the proposed rule may limit a banking entity’s ability to act in an AP capacity.849 One commenter estimated that APs that are banking entities make up between 20 percent to 100 percent of creation and redemption activity for individual ETFs, with an average of approximately 35 percent of creation and redemption activity across all ETFs attributed to banking entities. This commenter expressed the view that, if the rule limits banking entities’ ability to serve as APs, then individual investors’ investments in ETFs will become more expensive due to higher premiums and discounts versus the ETF’s NAV.850 A number of commenters stated that certain requirements of the proposed exemption may limit a banking entity’s ability to serve as AP to an ETF, including the proposed near term customer demand requirement,851 the proposed source of revenue requirement,852 and language in the proposal regarding arbitrage trading.853 With respect to the proposed near term customer demand requirement, a few commenters noted that this requirement could prevent an AP from building inventory to assemble creation units.854 Two other commenters expressed the view that the ETF issuer would be the banking entity’s ‘‘counterparty’’ when the banking entity trades directly with the ETF issuer, so this trading and inventory accumulation would meet the terms of the proposed requirement.855 To permit banking entities to act as APs, two commenters suggested that trading in the capacity of an AP should be deemed permitted market makingrelated activity, regardless of whether the AP is acting as a traditional market maker.856
viii. Arbitrage or Other Activities That
Promote Price Transparency and Liquidity In response to a question in the proposal,857 a number of commenters stated that certain types of arbitrage activity should be permitted under the market-making exemption.858 For example, some commenters stated that a banking entity’s arbitrage activity should be considered market making to the extent the activity is driven by creating markets for customers tied to the price differential (e.g., ‘‘box’’ strategies, ‘‘calendar spreads,’’ merger arbitrage, ‘‘Cash and Carry,’’ or basis trading) 859 or to the extent that demand is predicated on specific price relationships between instruments (e.g., ETFs, ADRs) that market makers must

860See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC. 861See Credit Suisse (Seidel). 862See RBC. 863See SIFMA et al. (Prop. Trading) (Feb. 2012). 864See Credit Suisse (Seidel); RBC. 865See RBC. 866See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; FTN; ISDA (Feb. 2012) (stating that arbitrage activities often yield positions that are ultimately put to use in serving customer demand and representing that the process of consistently trading makes a dealer ready and available to serve customers on a competitive basis). 867See JPMC (stating that firms commonly organize their market-making activities so that risks delivered to client-facing desks are aggregated and transferred by means of internal transactions to a single utility desk (which hedges all of the risks in the aggregate), and this may optically bear some characteristics of arbitrage, although the commenter requested that such activity be recognized as permitted market making-related activity under the rule); ISDA (Feb. 2012) (stating that in some swaps markets, dealers hedge through multiple instruments, which can give an impression of arbitrage in a function that is risk reducing; for example, a dealer in a broad index equity swap may simultaneously hedge in baskets of stocks, futures, and ETFs). But See Sens. Merkley & Levin (Feb.
2012) (‘‘When banks use complex hedging
techniques or otherwise engage in trading that is suggestive of arbitrage, regulators should require them to provide evidence and analysis demonstrating what risk is being reduced.’’). 868See FTN. 869See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; Goldman (Prop. Trading). One of these commenters stated that the customer-facing activity category of metrics, as well as other metrics, would be available to evaluate whether the trading unit is engaged in a directly customer-facing business and the extent to which its activities are consistent with the market-making exemption. See Goldman (Prop. Trading). 870See Johnson & Prof. Stiglitz. See also AFR et al. (Feb. 2012) (noting that arbitrage, spread, or carry trades are a classic type of proprietary trade). 871See Occupy. 872See, e.g., SIFMA et al. (Prop. Trading) (Feb.
2012) (stating that permitted activities should
include trading necessary to meet the relevant jurisdiction’s primary dealer and other requirements); JPMC (indicating that the exemption should cover all of a firm’s activities that are necessary or reasonably incidental to its acting as a primary dealer in a foreign government’s debt securities); Goldman (Prop. Trading); Banco de Me´xico; IIB/EBF. See infra notes 905 to 906 and accompanying text (addressing these comments). 873See Goldman (Prop. Trading). 874See Banco de Me´xico. 875See JPMC; Banco de Me´xico. These commenters stated that a primary dealer is required to assume positions in foreign sovereign debt even when near term customer demand is unpredictable. See id. 876See Banco de Me´xico (stating that primary dealers need to be able to profit from their positions in sovereign debt, including by holding significant positions in anticipation of future price movements, so that the primary dealer business is financially attractive); IIB/EBF (stating that primary dealers may actively Seek to profit from price and interest rate movements based on their debt holdings, which governments support as providing muchneeded liquidity for securities that are otherwise purchased largely pursuant to buy-and-hold strategies of institutional investors and other entities Seeking safe returns and liquidity buffers). 877See Goldman (Prop. Trading). 878See SIFMA et al. (Prop. Trading) (Feb. 2012). 879See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); SIFMA (Asset Mgmt.) (Feb. 2012). This issue is addressed in Part IV.A.3.c.1.c.iii., supra, and Part IV.A.3.c.2.c.iii., infra. 880See Credit Suisse (Seidel); Goldman (Prop. Trading); SIFMA (Asset Mgmt.) (Feb. 2012). 881See Goldman (Prop. Trading); SIFMA (Asset Mgmt.) (Feb. 2012). 882See SIFMA (Asset Mgmt.) (Feb. 2012). maintain.860 Similarly, another commenter suggested that arbitrage activity that aligns prices should be permitted, such as index arbitrage, ETF arbitrage, and event arbitrage.861 One commenter noted that many markets, such as futures and options markets, rely on arbitrage activities of market makers for liquidity purposes and to maintain convergence with underlying instruments for cash-settled options, futures, and index-based products.862 Commenters stated that arbitrage trading provides certain market benefits, including enhanced price transparency,863 increased market efficiency,864 greater market liquidity,865 and general benefits to customers.866 A few commenters noted that certain types of hedging activity may appear to have characteristics of arbitrage trading.867 Commenters suggested certain methods for permitting and monitoring arbitrage trading under the exemption. For example, one commenter suggested a framework for permitting certain arbitrage within the market-making exemption, with requirements such as:
(i) Common personnel with marketmaking activity; (ii) policies that cover the timing and appropriateness of arbitrage positions; (iii) time limits on arbitrage positions; and (iv) compensation that does not reward successful arbitrage, but instead pools any such revenues with market-making profits and losses.868 A few commenters represented that, if permitted under the rule, the Agencies would be able to monitor arbitrage activities for patterns of impermissible proprietary trading through the use of metrics, as well as compliance and examination tools.869 Other commenters stated that the exemption should not permit certain types of arbitrage. One commenter stated that the rule should ensure that relative value and complex arbitrage strategies cannot be conducted.870 Another commenter expressed the view that the market-making exemption should not permit any type of arbitrage transactions. This commenter stated that, in the event that liquidity or transparency is inhibited by a lack of arbitrage trading, a market maker should be able to find a customer who would seek to benefit from it.871
ix. Primary Dealer Activities
A number of commenters requested that the market-making exemption permit banking entities to meet their primary dealer obligations in foreign jurisdictions, particularly if trading in foreign sovereign debt is not separately exempted in the final rule.872 According to commenters, a banking entity may be obligated to perform the following activities in its capacity as a primary dealer: undertaking to maintain an orderly market, preventing or correcting any price dislocations,873 and bidding on each issuance of the relevant jurisdiction’s sovereign debt.874 Commenters expressed concern that a banking entity’s trading activity as primary dealer may not comply with the proposed near term customer demand requirement 875 or the proposed source of revenue requirement.876 To address the first issue, one commenter stated that the final rule should clarify that a banking entity acting as a primary dealer of foreign sovereign debt is engaged in primary dealer activity in response to the near term demands of the sovereign, which should be considered a client, customer, or counterparty of the banking entity.877 Another commenter suggested that the Agencies permit primary dealer activities through commentary stating that fulfilling primary dealer obligations will not be included in determinations of whether the market-making exemption applies to a trading unit.878
x. New or Bespoke Products or
Customized Hedging Contracts Several commenters indicated that the proposed exemption does not adequately address market making in new or bespoke products, including structured, customer-driven transactions, and requested that the rule be modified to clearly permit such activity.879 Many of these commenters emphasized the role such transactions play in helping customers hedge the unique risks they face.880 Commenters stated that, as a result, limiting a banking entity’s ability to conduct such transactions would subject customers to increased risks and greater transaction costs.881 One commenter suggested that the Agencies explicitly state that a banking entity’s general willingness to engage in bespoke transactions is sufficient to make it a market maker in unique products for purposes of the rule.882 Other commenters stated that banking entities should be limited in their ability to rely on the market-making exemption to conduct transactions in bespoke or

883See AFR et al. (Feb. 2012); Public Citizen. 884See AFR et al. (Feb. 2012). 885See Public Citizen. 886The final rule includes certain refinements to the proposed standard, which would have required that the market making-related activities of the trading desk or other organizational unit that conducts the purchase or sale are, with respect to the financial instrument, designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties. See proposed rule § __.4(b)(2)(iii). 887See supra Part IV.A.3.c.1.c.ii.; final rule § __.4(b)(5). 888See infra Part IV.A.3.c.3. (discussing the compliance program requirements); final rule § __.4(b)(2)(iii). 889See supra Part IV.A.3.c.2.b.i. 890This language has been added to the final rule to respond to commenters’ concerns that the proposed near term demand requirement would be unworkable in less liquid markets or would otherwise restrict a market maker’s ability to hold and manage its inventory in less liquid markets. See supra Part IV.A.3.c.2.b.ii. In addition, this provision is substantially similar to one commenter’s suggested approach of adding the phrase ‘‘based on the characteristics of the relevant market and asset class’’ to the proposed requirement, but the Agencies have added more specificity about the relevant characteristics that should be taken into consideration. See Morgan Stanley. 891See infra Part IV.A.3.c.3. 892As discussed further below, acquiring a position in a financial instrument in response to reasonably expected customer demand would not include creating a structured product for which there is no current customer demand and, instead, soliciting customer demand during or after its creation. See infra note 938 and accompanying text; Sens. Merkley & Levin (Feb. 2012). customized derivatives.883 For example, one commenter suggested that a banking entity be required to disaggregate such derivatives into liquid risk elements and illiquid risk elements, with liquid risk elements qualifying for the marketmaking exemption and illiquid risk elements having to be conducted on a riskless principal basis under § __ .6(b)(1)(ii) of the proposed rule. According to this commenter, such an approach would not impact the end user customer.884 Another commenter stated that a banking entity making a market in bespoke instruments should be required both to hold itself out in accordance with § __.4(b)(2)(ii) of the proposed rule and to demonstrate the purchase and the sale of such an instrument.885
c. Final Near Term Customer Demand
Requirement
Consistent with the statute, § __ .4(b)(2)(ii) of the final rule’s marketmaking exemption requires that the amount, types, and risks of the financial instruments in the trading desk’s market-maker inventory be designed not to exceed, on an ongoing basis, the reasonably expected near term demands of clients, customers, or counterparties, based on certain market factors and analysis.886 As discussed above in Part IV.A.3.c.1.c.ii., the trading desk’s market-maker inventory consists of positions in financial instruments in which the trading desk stands ready to purchase and sell consistent with the final rule.887 The final rule requires the financial instruments to be identified in the trading desk’s compliance program. Thus, this requirement focuses on a trading desk’s positions in financial instruments for which it acts as market maker. These positions of a trading desk are more directly related to the demands of customers than positions in financial instruments used for risk management purposes, but in which the trading desk does not make a market. As noted above, a position or exposure that is included in a trading desk’s marketmaker inventory will remain in its market-maker inventory for as long as the position or exposure is managed by the trading desk. As a result, the trading desk must continue to account for that position or exposure, together with other positions and exposures in its market-maker inventory, in determining whether the amount, types, and risks of its market-maker inventory are designed not to exceed, on an ongoing basis, the reasonably expected near term demands of customers. While the near term customer demand requirement directly applies only to the trading desk’s market-maker inventory, this does not mean a trading desk may establish other positions, outside its market-maker inventory, that exceed what is needed to manage the risks of the trading desk’s market makingrelated activities and inventory. Instead, a trading desk must have limits on its market-maker inventory, the products, instruments, and exposures the trading desk may use for risk management purposes, and its aggregate financial exposure that are based on the factors set forth in the near term customer demand requirement, as well as other relevant considerations regarding the nature and amount of the trading desk’s market making-related activities. A banking entity must establish, implement, maintain, and enforce a limit structure, as well as other compliance program elements (e.g., those specifying the instruments a trading desk trades as a market maker or may use for risk management purposes and providing for specific risk management procedures), for each trading desk that are designed to prevent the trading desk from engaging in trading activity that is unrelated to making a market in a particular type of financial instrument or managing the risks associated with making a market in that type of financial instrument.888 To clarify the application of this
standard in response to comments,889 the final rule provides two factors for assessing whether the amount, types, and risks of the financial instruments in the trading desk’s market-maker inventory are designed not to exceed, on an ongoing basis, the reasonably expected near term demands of clients, customers, or counterparties. Specifically, the following must be considered under the revised standard:
(i) The liquidity, maturity, and depth of the market for the relevant type of financial instrument(s),890 and (ii) demonstrable analysis of historical customer demand, current inventory of financial instruments, and market and other factors regarding the amount, types, and risks of or associated with positions in financial instruments in which the trading desk makes a market, including through block trades. Under the final rule, a banking entity must account for these considerations when establishing risk and inventory limits for each trading desk.891 For purposes of this provision, ‘‘demonstrable analysis’’ means that the analysis for determining the amount, types, and risks of financial instruments a trading desk may manage in its market-maker inventory, in accordance with the near term demand requirement, must be based on factors that can be demonstrated in a way that makes the analysis reviewable. This may include, among other things, the normal trading records of the trading desk and market information that is readily available and retrievable. If the analysis cannot be supported by the banking entity’s books and records and available market data, on their own, then the other factors utilized must be identified and documented and the analysis of those factors together with the facts gathered from the trading and market records must be identified in a way that makes it possible to test the analysis. Importantly, a determination of whether a trading desk’s market-maker inventory is appropriate under this requirement will take into account reasonably expected near term customer demand, including historical levels of customer demand, expectations based on market factors, and current demand. For example, at any particular time, a trading desk may acquire a position in a financial instrument in response to a customer’s request to sell the financial instrument or in response to reasonably expected customer buying interest for such instrument in the near term.892 In addition, as discussed below, this requirement is not intended to impede a trading desk’s ability to engage in

893The formation of structured finance products and securitizations is discussed in detail in Part IV.B.2.b. of this SUPPLEMENTARY INFORMATION. 894See final rule § __.4(b)(2)(iii)(B), (C). 895This natural hedge with futures would introduce basis risk which, like other risks of the trading desk, must be managed within the desk’s limits. 896See SIFMA (Asset Mgmt.) (Feb. 2012); T. Rowe Price; CIEBA; ICI (Feb. 2012) RBC. 897See Japanese Bankers Ass’n.; Credit Suisse (Seidel); Occupy; AFR et al. (Feb. 2012); Public Citizen. 898Final rule §ll.4(b)(3). 899See final rule §ll.4(b)(3)(i). The Agencies are using a $50 billion threshold for these purposes in recognition that firms engaged in substantial trading activity do not typically act as customers to certain market making-related activities that are consistent with and needed to facilitate permissible trading with its clients, customers, or counterparties, such as inventory management and interdealer trading. These activities must, however, be consistent with the analysis conducted under the final rule and the trading desk’s limits discussed below.893 Moreover, as explained below, the banking entity must also have in place escalation procedures to address, analyze, and document trades made in response to customer requests that would exceed one of a trading desk’s limits. The near term demand requirement is an ongoing requirement that applies to the amount, types, and risks of the financial instruments in the trading desk’s market-maker inventory. For instance, a trading desk may acquire exposures as a result of entering into market-making transactions with customers that are within the desk’s market-marker inventory and financial exposure limits. Even if the trading desk is appropriately managing the risks of its market-maker inventory, its marketmaker inventory still must be consistent with the analysis of the reasonably expected near term demands of clients, customers, and counterparties and the liquidity, maturity and depth of the market for the relevant instruments in the inventory. Moreover, the trading desk must take action to ensure that its financial exposure does not exceed its financial exposure limits.894 A trading desk may not maintain an exposure in its market-maker inventory, irrespective of customer demand, simply because the exposure is hedged and the resulting financial exposure is below the desk’s financial exposure limit. In addition, the amount, types, and risks of financial instruments in a trading desk’s marketmaker inventory would not be consistent with permitted marketmaking activities if, for example, the trading desk has a pattern or practice of retaining exposures in its market-maker inventory, while refusing to engage in customer transactions when there is customer demand for those exposures at commercially reasonable prices. The following is an example of the interplay between a trading desk’s market-maker inventory and financial exposure. An airline company customer may
seek to hedge its long-term exposure to price fluctuations in jet fuel by asking a banking entity to create a structured ten-year, $1 billion jet fuel swap for which there is no liquid market. A trading desk that makes a market in energy swaps may service its customer’s needs by executing a custom jet fuel swap with the customer and holding the swap in its market-maker inventory, if the resulting transaction does not cause the trading desk to exceed its market-maker inventory limit on the applicable class of instrument, or the trading desk has received approval to increase the limit in accordance with the authorization and escalation procedures under paragraph (b)(2)(iii)(E). In keeping with the marketmaking exemption as provided in the final rule, the trading desk would be required to hedge the risk from this swap, either individually or as part of a set of aggregated positions, if the trade would result in a financial exposure that exceeds the desk’s financial exposure limits. The trading desk may hedge the risk of the swap, for example, by entering into one or more futures or swap positions that are identified as permissible hedging products, instruments, or exposures in the trading desk’s compliance program and that analysis, including correlation analysis as appropriate, indicates would demonstrably reduce or otherwise significantly mitigate risks associated with the financial exposure from its market-making activities. Alternatively, if the trading desk also acts as a market maker in crude oil futures, then the desk’s exposures arising from its market-making activities may naturally hedge the jet fuel swap (i.e., it may reduce its financial exposure levels resulting from such instruments).895 The trading desk must continue to appropriately manage risks of its financial exposure over time in accordance with its financial exposure limits. As discussed above, several commenters expressed concern that the near-term customer demand requirement is too restrictive and that it could impede a market maker’s ability to build or retain inventory, particularly in less liquid markets where demand is intermittent.896 Because customer demand in illiquid markets can be difficult to predict with precision, market-maker inventory may not closely track customer order flow. The Agencies acknowledge that market makers will face costs associated with demonstrating that market-maker inventory is designed not to exceed, on an ongoing basis, the reasonably expected near term demands of customers, as required by the statute and the final rule because this is an analysis that banking entities may not currently undertake. However, the final rule includes certain modifications to the proposed rule that are intended to reduce the negative impacts cited by commenters, such as limitations on inventory management activity and potential restrictions on market making in less liquid instruments, which the Agencies believe should reduce the perceived burdens of the proposed
near term demand requirement. For example, the final rule recognizes that liquidity, maturity, and depth of the market vary across asset classes. The Agencies expect that the express recognition of these differences in the rule should avoid unduly impeding a market maker’s ability to build or retain inventory. More specifically, the Agencies recognize the relationship between market-maker inventory and customer order flow can vary across asset classes and that an inflexible standard for demonstrating that inventory does not exceed reasonably expected near term demand could provide an incentive to stop making markets in illiquid asset classes.
i. Definition of ‘‘Client,’’ ‘‘Customer,’’
and ‘‘Counterparty’’
In response to comments requesting further definition of the terms ‘‘client,’’ ‘‘customer,’’ and ‘‘counterparty’’ for purposes of this standard,897 the Agencies have defined these terms in the final rule. In particular, the final rule defines ‘‘client,’’ ‘‘customer,’’ and ‘‘counterparty’’ as, on a collective or individual basis, ‘‘market participants that make use of the banking entity’s market making-related services by obtaining such services, responding to quotations, or entering into a continuing relationship with respect to such services.’’ 898 However, for purposes of the analysis supporting the marketmaker inventory held to meet the reasonably expected near-term demands of clients, customers and counterparties, a client, customer, or counterparty of the trading desk does not include a trading desk or other organizational unit of another entity if that entity has $50 billion or more in total trading assets and liabilities, measured in accordance with §ll.20(d)(1),899 unless the

other market makers, while smaller regional firms may Seek liquidity from larger firms as part of their market making-related activities. 900See final rule §ll.4(b)(3)(i)(A), (B). In
Appendix C of the proposed rule, a trading unit
engaged in market making-related activities would have been required to describe how it identifies its customers for purposes of the Customer-Facing Trading Ratio, if applicable, including documentation explaining when, how, and why a broker-dealer, swap dealer, security-based swap dealer, or any other entity engaged in market making-related activities, or any affiliate thereof, is considered to be a customer of the trading unit. See Joint Proposal, 76 FR 68,964. While the proposed approach would not have necessarily prevented any of these entities from being considered a customer of the trading desk, it would have required enhanced documentation and justification for treating any of these entities as a customer. The final rule’s exclusion from the definition of client, customer, and counterparty is similar to the proposed approach, but is more narrowly focused on firms that have $50 billion or more trading assets and liabilities because, as noted above, the Agencies believe firms engaged in such substantial trading activity are less likely to act as customers to market makers than smaller regional firms. 901See Joint Proposal, 76 FR 68,960; CFTC Proposal, 77 FR 8439. 902See, e.g., Goldman (Prop. Trading) (explaining generally how exchange-based market makers operate). 903See ISDA (Feb. 2012). In addition, a number of commenters suggested that the rule should not limit broker-dealers from being customers of a market maker. See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit Suisse (Seidel); RBC; Comm. on Capital Markets Regulation. 904See AFR et al. (Feb. 2012); Occupy; Public Citizen. 905A primary dealer is a firm that trades a sovereign government’s obligations directly with the sovereign (in many cases, with the sovereign’s central bank) as well as with other customers through market making. The sovereign government may impose conditions on a primary dealer or require that it engage in certain trading in the relevant government obligations (e.g., participate in auctions for the government obligation or maintain a liquid secondary market in the government obligations). Further, a sovereign government may limit the number of primary dealers that are authorized to trade with the sovereign. A number of countries use a primary dealer system, including Australia, Brazil, Canada, China-Hong Kong, France, Germany, Greece, India, Indonesia, Ireland, Italy, Japan, Mexico, Netherlands, Portugal, South Africa, South Korea, Spain, Turkey, the U.K., and the U.S. See, e.g., Oliver Wyman (Feb. 2012). The Agencies note that this standard would similarly apply to the relationship between a banking entity and a sovereign that does not have a formal primary dealer system, provided the sovereign’s process functions like a primary dealer framework. 906See Goldman (Prop. Trading). See also supra
Part IV.A.3.c.2.b.ix. (discussing commenters’
concerns regarding primary dealer activity). Each suggestion regarding the treatment of primary dealer activity has not been incorporated into the rule. Specifically, the exemption for market making as applied to a primary dealer does not extend without limitation to primary dealer activities that are not conducted under the conditions of one of the exemptions. These interpretations would be inconsistent with Congressional intent for the statute, to limit permissible market-making activity through the statute’s near term demand requirement and, thus, does not permit trading without limitation. See SIFMA et al. (Prop. Trading) (Feb.
2012) (stating that permitted activities should
include trading necessary to meet the relevant jurisdiction’s primary dealer and other requirements); JPMC (indicating that the exemption should cover all of a firm’s activities that are necessary or reasonably incidental to its acting as a primary dealer in a foreign government’s debt securities); Goldman (Prop. Trading); Banco de Me´xico; IIB/EBF. Rather, recognizing that market making by primary dealers is a key function, the limits and other conditions of the rule are flexible enough to permit necessary market making-related activities. trading desk documents how and why such trading desk or other organizational unit should be treated as a customer or the transactions are conducted anonymously on an exchange or similar trading facility that permits trading on behalf of a broad range of market participants.900 The Agencies believe this definition is generally consistent with the proposed interpretation of ‘‘customer’’ in the proposal. The proposal generally provided that, for purposes of market making on an exchange or other organized trading facility, a customer is any person on behalf of whom a buy or sell order has been submitted. In the context of the over-the-counter market, a customer was generally considered to be a market participant that makes use of the market maker’s intermediation services, either by requesting such services or entering into a continuing relationship for such services.901 The definition of client, customer, and counterparty in the final rule recognizes that, in the context of market making in a financial instrument that is executed on an exchange or other organized trading facility, a client, customer, or counterparty would be any person whose buy or sell order executes against the banking entity’s quotation posted on the exchange or other organized trading facility.902 Under these circumstances, the person would be trading with the banking entity in response to the banking entity’s quotations and obtaining the banking entity’s market making-related services. In the context of market making in a financial instrument in the OTC market, a client, customer, or counterparty generally would be a person that makes use of the banking entity’s intermediation services, either by requesting such services (possibly via a request-for-quote on an established trading facility) or entering into a continuing relationship with the banking entity with respect to such services. For purposes of determining the reasonably expected near-term demands of customers, a client, customer, or counterparty generally would not include a trading desk or other organizational unit of another entity that has $50 billion or more in total trading assets except if the trading desk has a documented reason for treating the trading desk or other organizational unit of such entity as a customer or the trading desk’s transactions are executed anonymously on an exchange or similar trading facility that permits trading on behalf of a broad range of market
participants. The Agencies believe that this exclusion balances commenters’ suggested alternatives of either defining as a client, customer, or counterparty anyone who is on the other side of a market maker’s trade 903 or preventing any banking entity from being a client, customer, or counterparty.904 The Agencies believe that the first alternative is overly broad and would not meaningfully distinguish between permitted market making-related activity and impermissible proprietary trading. For example, the Agencies are concerned that such an approach would allow a trading desk to maintain an outsized inventory and to justify such inventory levels as being tangentially related to expected market-wide demand. On the other hand, preventing any banking entity from being a client, customer, or counterparty under the final rule would result in an overly narrow definition that would significantly impact banking entities’ ability to provide and access market making-related services. For example, most banks look to market makers to provide liquidity in connection with their investment portfolios. The Agencies further note that, with respect to a banking entity that acts as a primary dealer (or functional equivalent) for a sovereign government, the sovereign government and its central bank are each a client, customer, or counterparty for purposes of the marketmaking exemption as well as the underwriting exemption.905 The Agencies believe this interpretation, together with the modifications in the rule that eliminate the requirement to distinguish between revenues from spreads and price appreciation and the recognition that the market-making exemption extends to market makingrelated activities appropriately captures the unique relationship between a primary dealer and the sovereign government. Thus, generally a banking entity may rely on the market-making exemption for its activities as primary dealer (or functional equivalent) to the extent those activities are outside of the underwriting exemption.906 For exchange-traded funds (‘‘ETFs’’) (and related structures), Authorized Participants (‘‘APs’’) are generally the conduit for market participants seeking to create or redeem shares of the fund

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