Volcker Rule: Impact On Investment Management Firms?

The Volcker Rule is a federal regulation that prohibits banks from conducting certain investment activities with their own accounts and limits their dealings with hedge funds and private equity funds. The rule was proposed by American economist and former Federal Reserve Chairman Paul Volcker in 2010 and was implemented in 2015. It restricts banking entities from engaging in proprietary trading and from owning, sponsoring, or having certain relationships with a hedge fund or private equity fund. The rule aims to protect bank customers by preventing banks from making certain types of speculative investments that contributed to the 2007–2008 financial crisis. So, does the Volcker Rule apply to investment management firms?

Banks' prohibited activities

The Volcker Rule prohibits banks from engaging in certain activities that are deemed too high-risk and speculative. These prohibited activities include:

Proprietary Trading

The Volcker Rule generally prohibits banks from engaging in proprietary trading, or trading on their own accounts with their customer's deposits. This includes restrictions on short-term trading of securities, derivatives, commodity futures, and options. However, there are some exemptions, including market-making, underwriting, and trading outside the United States.

Investing in or Sponsoring Hedge Funds and Private Equity Funds

The Volcker Rule also bars banks from investing in or sponsoring hedge funds and private equity funds, often referred to as "covered funds." This restriction aims to prevent banks from taking on too much risk and making speculative investments that do not benefit their customers.

Certain Transactions with Covered Funds

The Volcker Rule establishes special restrictions on transactions between a covered fund and a bank that serves as its investment manager, investment adviser, organizer, or sponsor. These restrictions, known as "Super 23A" and "Super 23B," prohibit certain transactions and require any transactions to be on arms-length terms.

Conflict of Interest Trading

The Volcker Rule prohibits conflict of interest trading, where banks create instruments based on junky assets and then bet against their clients by betting on their failure.

High-Risk Activities

The Volcker Rule aims to prevent banks from engaging in high-risk activities that could expose the institution or the broader financial system to instability.

Speculative Investments

The Volcker Rule was created in response to the 2007-2008 financial crisis, with the goal of preventing banks from making certain types of speculative investments that contributed to that crisis.

Hedge funds and private equity funds ownership

The Volcker Rule, a federal regulation, generally prohibits banks from engaging in certain investment activities with their own accounts and limits their dealings with hedge funds and private equity funds, also known as covered funds. The rule bars banks from using their own accounts for short-term proprietary trading of securities, derivatives, and commodity futures, as well as options on any of these instruments. The Volcker Rule also prohibits banks from acquiring or retaining ownership interests in hedge funds or private equity funds, with certain exemptions.

Hedge funds and private equity funds are alternative investments that have become increasingly popular since the mid-1990s. They appeal primarily to high-net-worth individuals and are usually structured as limited partnerships. Both types of funds involve paying managing partners basic fees as well as a percentage of the profits.

Hedge funds are alternative investments that use pooled funds and employ a variety of strategies to earn returns for their investors. The aim of a hedge fund is to provide the highest investment returns possible as quickly as possible. To achieve this goal, hedge fund investments are primarily in highly liquid assets, enabling the fund to take profits quickly on one investment and then shift funds into another investment that is more immediately promising. Hedge funds tend to use leverage, or borrowed money, to increase their returns. But such strategies are risky—highly leveraged firms were hit hard during the 2008 financial crisis.

Hedge funds invest in virtually anything and everything—individual stocks (including short selling and options), bonds, commodity futures, currencies, arbitrage, derivatives—whatever the fund manager sees as offering high potential returns in a short period of time. The focus of hedge funds is on maximum short-term profits.

Hedge funds are rarely accessible to the majority of investors; instead, hedge funds are geared toward accredited investors, as they need less SEC regulation than other funds. An accredited investor is a person or a business entity who is allowed to deal in securities that may not be registered with financial authorities. Hedge funds are also notoriously less regulated than mutual funds and other investment vehicles.

In terms of costs, hedge funds are pricier to invest in than mutual funds or other investment vehicles. Instead of charging an expense ratio only, hedge funds charge both an expense ratio and a performance fee.

Private equity funds more closely resemble venture capital firms in that they invest directly in companies, primarily by purchasing private companies, although they sometimes seek to acquire controlling interest in publicly traded companies through stock purchases. They frequently use leveraged buyouts to acquire financially distressed companies.

Unlike hedge funds focused on short-term profits, private equity funds are focused on the long-term potential of the portfolio of companies they hold an interest in or acquire. Once they acquire or control interest in a company, private equity funds look to improve the company through management changes, streamlining operations, or expansion, with the eventual goal of selling the company for a profit, either privately or through an initial public offering in the stock market.

To achieve their aims, private equity funds usually have, in addition to the fund manager, a group of corporate experts who can be assigned to manage the acquired companies. The very nature of their investments requires their more long-term focus, looking for profits on investments to mature in a few years rather than having the short-term quick-profit focus of hedge funds.

There are several differences between hedge funds and private equity funds in terms of time horizon, investment risk, lock-up and liquidity, and investment structure. Hedge funds are focused on primarily liquid assets, allowing investors to usually cash out their investments in the fund at any time. In contrast, the long-term focus of private equity funds usually dictates a requirement that investors commit their funds for a minimum period of time, typically at least three to five years, and often from seven to ten years.

There is also a substantial difference in risk level between hedge funds and private equity funds. While both practice risk management by combining higher-risk investments with safer investments, the focus of hedge funds on achieving maximum short-term profits necessarily involves accepting a higher level of risk.

Both hedge funds and private equity typically require large balances, anywhere from $100,000 to upwards of a million dollars or more per investor. Hedge funds may then lock those funds up for a period of months to a year, preventing investors from withdrawing their money until that time has elapsed. The lock-up period for a private equity fund will be far longer, such as three, five, or seven years. This is because a private equity investment is less liquid and needs time for the company being invested in to turn around.

Most hedge funds are open-ended, meaning that investors can continually add or redeem their shares in the fund at any time. Private equity funds, on the other hand, are closed-ended, meaning that new money cannot be invested after an initial period has expired.

Exceptions to the rule

The Volcker Rule, a federal regulation, prohibits banks from conducting certain investment activities with their own accounts and limits their dealings with hedge funds and private equity funds (also known as covered funds). The rule was proposed by American economist and former United States Federal Reserve Chairman Paul Volcker in 2010 to restrict banks from making speculative investments that do not benefit their customers and contributed to the 2007-2008 financial crisis.

While the Volcker Rule sets out to prohibit certain practices, there are exceptions to the rule. Banks are still allowed to engage in market making, underwriting, hedging, trading government securities, insurance company activities, and acting as agents, brokers, or custodians. These activities are permitted as they are considered important customer-oriented financial services. Banks may continue to offer these services to generate profits, as long as they do not create a material conflict of interest, expose the institution to high-risk assets or trading strategies, or generate instability within the bank or the US financial system.

Another exception to the Volcker Rule is for smaller banks, known as community banks. Banks with total consolidated assets of $10 billion or less and total trading assets and liabilities of 5% or less of total consolidated assets are generally exempt from the rule. This exemption recognises the lower risk profile of smaller banks and reduces the compliance burden on these institutions.

In addition, there are specific exceptions for certain types of investments and trading activities. For example, proprietary trading in treasuries, bonds issued by government-backed entities, and municipal bonds is exempted. Furthermore, a form of permitted proprietary trading is allowed based on Reasonably Expected Near-Term Demand (RENTD) for market-making activities. Banks can also invest a limited amount (3%) of Tier 1 capital into hedge funds and private equity funds, which can exceed $6 billion annually for larger banks.

The Volcker Rule has undergone revisions and amendments since its implementation, with some arguing for simpler and less restrictive regulations. These changes have aimed to clarify and streamline the rule, making it easier for banks and regulators to comply with and enforce. However, critics have argued that these relaxations may weaken consumer protections and enable banks to engage in high-risk activities.

Compliance and reporting requirements

The Volcker Rule, a federal regulation, restricts banking entities from engaging in proprietary trading and from owning, sponsoring, or having certain relationships with a hedge fund or private equity fund. Compliance requirements vary depending on the size of the banking entity.

Smaller institutions are subject to less stringent compliance and reporting requirements. For instance, banking entities with total consolidated assets of $10 billion or less may incorporate their Volcker Rule compliance measures into their existing compliance programs.

On the other hand, banking entities with more than $10 billion but less than $50 billion in total consolidated assets are mandated to implement a separate compliance program. This program must include written policies and procedures, a system of internal controls, a management framework, independent testing and audits, training for relevant personnel, and comprehensive record-keeping.

Meanwhile, banking entities with total consolidated assets of $50 billion or more face even more stringent compliance requirements.

In terms of reporting, banking entities engaged in significant trading must submit periodic reports to their primary regulatory agencies, providing a range of quantitative measurements regarding their proprietary trading activities. The specific reporting requirements depend on the amount of the entity's trading assets and liabilities. For instance, any U.S. banking entity with global trading assets and liabilities exceeding $50 billion over four quarters is mandated to file monthly reports on its proprietary trading activities.

It is important to note that the Volcker Rule does not apply to all banking entities. Banks that do not have more than $10 billion in total consolidated assets and do not have total trading assets and liabilities of 5% or more of total consolidated assets are excluded from the Volcker Rule.

Rule amendments and extensions

The Volcker Rule, named after economist and former Federal Reserve Chair Paul Volcker, has undergone several amendments and extensions since its proposal in 2010. The rule aims to restrict high-risk, speculative trading activities by banks, such as proprietary trading or investing in or sponsoring hedge funds or private equity funds. While it generally prohibits banking entities from engaging in such activities, there have been amendments to clarify and simplify the rule's application.

On May 30, 2018, Federal Reserve board members, led by Chair Jerome "Jay" Powell, voted to push forward a proposal to loosen the restrictions around the Volcker Rule and reduce compliance costs for banks. The goal was to replace complex and inefficient requirements with a streamlined set of rules. This proposal led to amendments that drew on the collective experience of the Volcker Rule agencies in implementing and overseeing compliance with the rule.

On January 30, 2020, the Federal Reserve, along with other regulatory agencies, put forward a proposal to amend the Volcker Rule's "covered funds" restrictions. These changes aimed to shrink the types of funds for which banks face investment limitations, allowing them to invest in venture capital and securitized loans more easily. The proposal was adopted on June 25, 2020, with Federal Deposit Insurance Corp. (FDIC) officials stating that it would allow banks to make large investments in venture capital and similar funds.

The Volcker Rule has also been extended multiple times to give banks more time to conform their investments and relationships with covered funds. For example, on December 18, 2014, the Federal Reserve extended the conformance period for "legacy covered funds" until July 21, 2016, and indicated a likely further extension to July 21, 2017. Additionally, the Federal Reserve has granted banking entities additional one-year extensions to conform their ownership interests in and sponsorship of certain collateralized loan obligations.

The rule has also undergone amendments to exclude community banks from its scope. Banks with total consolidated assets of $10 billion or less and total trading assets and liabilities of 5% or less of total consolidated assets are generally exempt from the Volcker Rule. These amendments highlight the ongoing efforts to improve and streamline the regulations implementing the Volcker Rule, ensuring that it effectively achieves its intended objectives without imposing undue burdens on market participants.

Frequently asked questions