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The so-called Volcker Rule, as required to be implemented by the Dodd-Frank Act, generally prohibits any banking entity from engaging in proprietary trading.  The final rule has been adopted by the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System; the Federal Deposit Insurance Corporation and the Securities and Exchange Commission, or the Agencies. The final rule includes exemptions from the prohibition on proprietary trading in several areas, including for underwriting, market-making and hedging.  Each of those three exemptions has restrictions on certain compensation arrangements.

Underwriting Exemption

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 designed not to reward or incentivize prohibited proprietary trading.   The Agencies do not intend to preclude an employee of an underwriting desk from being compensated for successful underwriting, which involves some risk-taking.

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 did not adopt an approach that prevents an employee from receiving any compensation related to profits arising from an unsold allotment, 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.  The Agencies also did not require compensation to be vested for a period of time.

Market-Making Exemption

Similar to the proposed rule, the market-making exemption requires that the compensation arrangements of persons performing the banking entity’s market making-related activities, as described in the exemption, are designed not to reward or incentivize prohibited proprietary trading.  The language of the final compensation requirement has been modified in response to comments expressing concern about the proposed language regarding “proprietary risk-taking.”  The Agencies note that the Agencies do not intend to preclude an employee of a market-making desk from being compensated for successful market making, which involves some risk-taking.

The Agencies continue to hold the view that activities for which a banking entity has established a compensation incentive structure that rewards speculation in, and appreciation of, the market value of a position held in inventory, rather than use of that inventory to successfully provide effective and timely intermediation and liquidity services to customers, are inconsistent with permitted market making-related activities. Although a banking entity relying on the market-making exemption may appropriately take into account revenues resulting from movements in the price of principal positions to the extent that such revenues reflect the effectiveness with which personnel have managed retained principal risk, a banking entity relying on the market-making exemption should provide compensation incentives that primarily reward customer revenues and effective customer service, 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 market-making exemption.

Hedging Exemption

The proposed rule required that the compensation arrangements of persons performing risk-mitigating hedging activities be designed not to reward proprietary risk-taking.  In the proposal, the Agencies stated that hedging activities for which a banking entity has established a compensation incentive structure that rewards speculation in, and appreciation of, the market value of a covered financial position, rather than success in reducing risk, are inconsistent with permitted risk-mitigating hedging activities.

The final rule substantially retains the proposed requirement that the compensation arrangements of persons performing risk-mitigating hedging activities be designed not to reward prohibited proprietary trading. The final rule was also modified to make clear that rewarding or incentivizing profit making from prohibited proprietary trading is not permitted.

The Agencies recognize that compensation, especially incentive compensation, may be both an important motivator for employees as well as a useful indicator of the type of activity that an employee or trading desk is engaged in. For instance, an incentive compensation plan that rewards an employee engaged in activities under the hedging exemption based primarily on whether that employee’s positions appreciate in value instead of whether such positions reduce or mitigate risk would appear to be designed to reward prohibited proprietary trading rather than risk-reducing hedging activities. Similarly, a compensation arrangement that is designed to incentivize an employee to exceed the potential losses associated with the risks of the underlying position rather than reduce risks of underlying positions would appear to reward prohibited proprietary trading rather than risk-mitigating hedging activities. The Agencies believe banking entities should review its compensation arrangements in light of the guidance and rules imposed by the appropriate Federal supervisor for the entity regarding compensation.

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