OfficeoftheComptrolleroftheCurrency 250EStreet,SW. MailStop23 Washington,DC 20219 13February2012 Re:ProhibitionsandRestrictionsonProprietaryTradingandCertainInterestsIn,andRelationshipsWith, HedgeFundsandPrivateEquityFunds.

s. DearSirs, Thank you for the opportunity to respond to your notice of proposed rulemaking, Prohibitions and Restrictions on Proprietary Trading and Certain Interests In, and Relationships With, Hedge Funds and PrivateEquityFunds. Throughout, the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), and the Securities and Exchange Commission(SEC),willbereferredtoastheAgencies. TheInternationalCentreforFinancialRegulation(ICFR)aimstoprovideafreshperspectiveonthechallenges of regulating global markets. As a nonpartisan organisation, with the support of both industry and government, we act as a catalyst for dialogue, thought leadership and scholarship in this critical area. We alsosupportpracticaltraininginitiativestoimproveunderstandingamongpractitionersandregulators.Our job is to encourage dialogue that identifies best practice across the traditional financial centres in the Americas,EuropeandAsiaandembracesemerginganddevelopingeconomiesworldwide.Tothisend,when theICFRhasrelevantexpertiseorevidenceofbestpracticethat canberelevant,itsubmitscommentson rulemaking. 1 Wewilllimitouranswertothoseareasinwhichwehavetheexpertisetooffersubstantivecomment.Our comments are split into two sections, the first comprising general remarks about the direction of the proposal,andthesecondlookingatspecificissuesandquestions. 1GeneralComments TheICFRwhollysupportstheultimateaimofremovingtheprincipalagentproblemofproprietarytrading. Effortstodatetousefirewallsandgreyliststoseparateclientinformationandflowsfromreachingthose taking positions within the same institutions have not been entirely successful. However, the size and complexityoffinancialinstitutions,togetherwithtechnologywhichpermits,andregulationswhichrequire, theaggregationofinformation,makeitincreasinglydifficulttoensurethatinformationremainsinspecific
1

Formoreonourorganisation,pleaseseewww.icffr.org

InternationalCentreforFinancialRegulation,5thFloor,41Moorgate,LondonEC2R6PP,UnitedKingdom Telephone:+44(0)2073745560Fax+44(0)2073745570www.icffr.org
InternationalCentreforFinancialRegulationisincorporatedasacompanylimitedbyguaranteeinEnglandandWales th CompanyNumber6625422RegisteredOffice5 Floor,41Moorgate,LondonEC2R6PP,UnitedKingdom

 silosintheinstitution.Moreover,aswewillexplaininmoredetailbelow,thereisanenormousgreyarea betweenclearproprietarytradingandclearagencybusiness. However, rather than going back preGlassSteagall to the Pecora hearings and trying to genuinely split institutions that handle transactions on an agency basis from institutions that trade solely for their own account,theproposalshaveoptedforafarmoreconvolutedsolutionthatleadsustoask:whatpreciselyisit thatthisruleseekingtostop?AclearandconciseresponseisnotapparentfromeitherthetextoftheDodd FrankAct,ortheAgenciesproposals.Assuch,wedonotbelievetheproposedrule,asstructured,tobea practicableorsustainablepieceofregulationwhichtakessufficientconsiderationofthelongtermneedto putfinancialmarketsonaclearerandmorestablefooting. Neithertheprincipleofproprietarytradingnortheprincipleofrisktakinginthenameofprofitisinherently flawed. Rather, legislators and regulators are grappling with an historical problem; proprietary trading in highriskinstrumentswasundertakenbyinstitutionswhichdidnotbearthedownsiderisksoftheiractions. In many cases, these institutions benefited from asymmetrical information at the expense of their clients and the wider community of investors, and ultimately the taxpayer. Disentangling the principles from the historicalcontingencies,whichisessentialinordertocreatesustainablenewregulation,isdifficult. But the ICFR believes that the core principles here relate to conflicts of interest and the corporate governanceoflargefinancialinstitutions.Proprietarytradingactivityisoftenimplicatedincertainaspectsof the financial crisis and in the failure of firms in the years subsequently (notably MF Global). But what is relevanthereisnotproprietarytradingperse,butthegrowthofhugelyrisky,complex,opaque,institutions litteredwithmisalignedincentives. Anattempttopreventthesortsofactivitieswhichledtothefinancialcrisismightplausiblyrestoninitiatives to mitigate conflicts of interest, rationalise business lines to improve resolvability, increase disclosure, improve internal risk oversight processes, improve corporate governance structures, increase capital requirements for risky instruments, mandate maximum leverage thresholds and minimum liquidity requirements, set position limits for certain instruments, and improve systemic oversight through macro prudentialregulationandsupervision.Indeed,manyprogrammesexistthroughwhichtheseissuesarebeing addressed,bothdomesticallyandinternationally.A partialcatalogueofthese initiativesinclude: theBasel Committee on Banking Supervision (BCBS) has revised its standards for capital; it has set out multiple liquidity regimes in the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR); it has introduced a leverage limit; it has revised Pillar II of the regime to improve risk management and related governanceissues;andithasstrengthenedPillarIIIdisclosurerequirements.ThroughtheOfficeofFinancial Research(OFR),USauthoritieswillhavethecapacitytocollectdataonpositionsandcounterparties,which the Financial Stability Oversight Council (FSOC) will be able to monitor as part of its ongoing macro prudential supervision, with a suitably systemwide perspective. Macroprudential regulation is evolving quickly, with central banks, national regulators, and transnational institutions developing new tools and perspectives.TheFSBhasrecentlycreatedanexpertgroupofinternationalregulatorstocontinueworkon aninternationallystandardisedLegalEntityIdentifier(LEI),inadditiontoexistingworkdonebyUSandother authorities,inordertomakecounterpartyidentificationclearerandmoreconsistent.Thisistosaynothing ofworkdoneonresolutionregimesbyawholehostofinternationalanddomesticagencies,whichseekto make the structure of financial firms more clear and amenable to monitoring. These are but a few of the 2|I C F R

 multipleinitiativeswhichareaimedatresolvingdeficienciesintheregulatoryarchitectureandthefinancial systembeyondregulation. Howandwheredoesthecurrentproposalsitinamongstthisraftofinternationalanddomesticwork?To take just one example, consider the new liquidity rules contained in Basel III. These international rules requirebankstoholdsufficientliquiditytomanageathirtydayperiodofstress,aswellastohaveastable sourceoffundingovera12monthperiod.HowwillthebanonproprietarytradinginnonUSgovernment securitiesaffectbanksabilitiestomeettheserequirementsinthelongterm?Moreover,theimpactofthe Volcker rule on the future of a liquid, efficient market for securities in the United States needs also to be considered.Thereislittleindicationthatsuchissueshavebeenconsidered. PaulVolckerframedhisintentionsfortheruleinsimpleterms: "If you are going to be a commercial bank, with all the protections that implies, you shouldn't be doingthisstuff.Ifyouaredoingthisstuff,youshouldn'tbeacommercialbank. 2 ThisgetsattheessenceofthemotivationfortheVolckerruleasawaytolimitthemoralhazardofallowing institutions which benefit from deposit insurance to engage in proprietary trading. Whether or not the currentproposalreducesthismoralhazardornot,whatisclearisthattheproposaldoesnotmanagetodo anythingwhichcanbesummedupintwosentences. When the UK authorities were hearing testimony from experts about reforming the banking system, ProfessorCharlesGoodhartcommented: Oneoftheconsiderationsthatyouhavetohaveisactuallywhatyouwantyourbankingsystemto do.[...]Howsafeandhowsmalldoyouwantthebankingsystemtobe?Ifyoumakeyourbanking systemsaferandsmaller,whathappenstothefinancingofyourcompanies?Youaregoingtopush all the financial intermediation probably back on to the market. Will that make the world safer or willitmakeitmoredangerous? 3 Initsreport,theUKTreasurynotedfurther: Policymakers,nationallyandinternationally,willneedtodecideontheirprioritiesforthebanking system.Alastingframeworkwillonlycomeaboutoncethesedecisionshavebeenmade. 4 Unfortunatelylegislationandpolicyhavebeenmadebeforeathoughtfulconsiderationoftheseissues.As theglobaleconomyhasenteredafurtherperiodofsignificantdifficultyanduncertainty,withpolicymakers reviewing their attitudes towards growth and stability, it is increasingly important that policymakers and regulatorsworktoachieveconsensusandclarityoverwhattheywantfromthefinancialsystemingeneral, aswellasfromindividualsectorssuchasbankingmorespecifically.
2

InterviewwithTheNewYorker,26July2012,availableonlineat http://www.newyorker.com/reporting/2010/07/26/100726fa_fact_cassidy 3 Availableonlineathttp://www.publications.parliament.uk/pa/cm200910/cmselect/cmtreasy/261/26105.htm 4 Ibid

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 Thelackofclarityintheaimsoftheruleismadeworsebythelevelofcomplexitywhichistheinevitable resultoftryingtocraftarulewhichcontainsalargenumberofexemptions.Thisiscompoundedbythefact thattheruletriestodistinguishmarketmakingfromproprietarytradingonthebasisoftheintentionofa trade by using quantitative metrics and historical comparisons. The sheer level of work involved in such a process in terms of even constructing adequate data gathering and monitoring techniques, let alone in interpreting the information correctly and consistently, will be extensive. The fact that the rule requires bankstodevelopawholecomplianceprogrammeforthissinglerulespeaksvolumes. However, regulators, like the regulated, must choose a risk appetite, and recognize that the regulations imposedwillhaveacostnotonlyontheinstitution,butalsoonitsclients,andthewidereconomyinterms ofgrowthandtaxrevenues.Proportionalityiscritical.Thisisalessonwhichiscurrentlybeingrelearned.It isalsooneofthemainforcesbehindthereregulatorydrive,wheretheperceptionisthatactivitieswhich have such socially detrimental consequences must be regulated more strictly, with broader economic objectivesincreasinglybeingtakenintoaccountaswemoveawayfromthecrisis. Wedonotbelievetheproposedrule,asstructured,representsapracticable,sustainablepieceofregulation. Theclaritywhichregulationsneedisremovedbythedifficultiesofframingmanageableexemptions,aswell asthecomplexityofcoordinationamongfiveorganisations.Weadoptthisviewnotbecausewesympathise with the firms who will have to comply, but because the lack of clarity and serious scope for unforeseen consequencesmaketherule,andtheactivitiesitisintendedtogovern,opaque. The ICFR is concerned that the division of responsibilities for monitoring the implementation of the rule amongtheagenciesisnotclearandcouldleadtoregulatoryunderlap,wherebycertainaspectsoftherule fall between agencies, with no agency claiming responsibility for the whole. We are concerned about the potentialforinconsistentapplicationorenforcementoftheVolckerruleaslikelytoleadtosuchunderlap given the difficulties of coordinating multiple agencies across multiple institutions. Added to testimony by regulatoryofficialstoCongressinJanuary2012thatsomeagenciesdonothavethestaffnortheskillsets necessary to implement and enforce this rule as present, such issues must be addressed before this provisiongainstheforceoflaw. TheVolckerruleisoftencomparedtotheGlassSteagallActbecauseofthewayinwhichitseekstoprevent certainactivitythroughstructuralmeasures.TherealisedtemptationleadingtotherepealofGlassSteagall inthelate20 thcenturywasheightenedbycompetitivenessissuesraisedbyUSbankswhowereunableto conductasbroadarangeofactivitiesasforeigncompetitorsoperatingasuniversalbanks.Thetextofthe currentproposalexplicitlyrecognisesthattherewillbecompetitivenessconsequencesforUSbanks,andthis has been raised by a number of officials elsewhere. International consistency in the regulation of global financial activity, within the context of the level of development of local economies and capital markets, shouldbeparamountforstabilityreasons.Theintroductionofanentirelydifferentbankingstructureinthe USforinternationallyactivebanksandinvestmentbanksneedstobeconsideredasatradeoffbetweenthe simultaneous goals of systemic stability and the need for strong international financial players to support Americancompaniesandinterestsabroad. TheAgenciesarerighttoaskforspecificsontheunintendedconsequencesofmanyofthetopics.However, rather than unintended consequences, the ICFR would focus on the consequences of complexity. It is not 4|I C F R

 simply that the consequences of certain aspects of the rule may be unintended, but that they are unpredictable on account of the intricacy of the rule. Such consequences are, by their very nature, more difficulttoprotectagainstandcontrol.Complexitybreedsunpredictability.Bothregardlessof,andbecause of, the myriad of agencies with oversight responsibility, it will be difficult to keep a holistic view of the consequences of the rule, operating as it does over multiple agencies, and requiring as it does such vast compliancematerial. TheICFRbelievesthatthereisaninherentproblemintryingtodifferentiateproprietarytradingfrommarket making.Thisis,ofcourse,notlostontheAgencies,whosetaskitistoimplementarulewhichisfaithfulto the DoddFrank Act, already passed into law, which creates a dependence upon definitions and yet shies awayfromactuallyprovidinganumberofthosedefinitions.WhendecidinghowtodraftSection619ofthe DoddFrankAct,Congressfacedachoicebetweentwoextremes,eachwiththeirownrisks:bankscouldbe allowedtoengageinmarketmakingwhiletheyenjoytheprotectionsinvolved,ormarketmakingcouldbe forcedentirelyoutsidethebankingsector,andhenceoutoftheregulatedsector.Instead,theyoptedfora middle path: banks would be allowed to be involved in marketmaking, to the extent that those activities are designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties. The intention here was to prevent a complete withdrawal of important market making activityfromthebankingsector,whileseekingtoeliminatetheaspectsofthatactivitywhichcouldbeused todisguiseproprietarytrading.Butinpractice,mostmarketparticipantswilltellyouthatthisdistinctionis almost impossible to draw. Is an intraday position against client orders to ensure a unit ends the day hedgedmarketmakingorpositiontaking? TheDoddFrankActdoesnotprovidesufficientlywellfortheconsequencesofthistradeoff.TheAgencies havebeenlefttofillintheruleandmakeoperationalasystemwhichdoesnotseempracticableeitherina waywhichisconsistentwiththeoriginalintentionofthestatute,orinawaywhichisbeneficialtofinancial stability. The six factors the Agencies outline as relevant for distinguishing permitted market making from prohibited proprietary trading seem broadly sensible in principle. But it is the practical workings of the proposals which are of concern, and not the logic of the reasoning involved. We will return to this point later. As noted by staff at the International Monetary Fund (IMF), the proposed system for identifying prohibited transactions is more suited to an expost imposition of charges for noncompliance with the rules requirements rather than as an exante or concurrent identification device by supervisors. In other words,itisnotdesignedtotellapartindividualmarketmakingorhedgingtransactionsfromopportunistic proprietarytrades. 5 TheICFRdoesnotbelievethatthiswastheintentionoftherule,anditdoesnotseem toustobeasuitablesecondbest. Furthermore,therehasnotbeenasufficientamountofattentionpaidtotheshorttermconsequencethata largeamountofmarketmakingactivitywillbeprohibitedfrom themiddleof2012,withoutother market participantsinthefinancialsystemhavingthecapacitytoabsorbthisactivityquicklyandefficiently.Inthe longterm, it is likely that nonbanks will step into the vacuum left by the proposed rule. However, the financial stability consequences in the immediate shortterm will be negative. It is peculiar that one consequenceofthisruleisthatpolicymakersandregulatorsmusthopethatmoreactivityisundertakenby the underregulated shadow banking sector in order to maintain sufficient liquidity in the markets.
5

SeeJulianT.S.ChowandJaySurti,MakingBanksSafer:CanVolckerandVickersDoIt?,IMFWorkingPaper WP/11/236,availableonlineathttp://www.imf.org/external/pubs/ft/wp/2011/wp11236.pdf

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 Increasingthesizeoftheshadowbankingworldisoftencitedasanundesirableunintendedconsequence ofnewrules,butitseemsthattheVolckerrulehasbeenformulatedwiththispreciselyinmind.TheICFR wouldliketo,onceagain,stresstheunpredictabilityofthis,especiallyinthecontextofasystemwherefull scalemacroprudentialsupervisionisnotyetoperational. Beyondtheseproblems,andparticularlypertinentfromourperspectiveasaninternationalorganisation,are the extensive extraterritorial implications of the proposals. For nonUS banks and financial firms the proposals are very consequential in terms of compliance. Even for those firms who are subject to exemptions there will be an enormous amount of work involved in terms of ensuring that they are not caught through their interactions with other market participants. For instance, in order to meet the exemptionforforeigntradingbyensuringthatallproprietarytradingactivitytakesplacesolelyoutsidethe UnitedStates,firmswouldappeartohavetocheckeverymemberofanyfundactingasacounterpartyto seewhetherthosememberswereresidentintheUnitedStates.Wherewilltheburdenfallhere?Towhat extentwillcompaniesberesponsibleforensuringcompliancewithsuchrequirements,andtowhatextent willtheybepermittedtorelyontheattestationoftheircounterparties?Thereseemstobethepotentialfor nonUSbankstobecomesubjecttotherequirementsofaUSruleonaccountofreportingerrorsmadeby counterparties,whichthemselvesmaynotevenbelocatedintheUnitedStates.Wewilldiscusstheseissues inmoredetailinthenextsection. Insummary,theICFRbelievesthattheproposedruleisnotfitforimplementation.Thesheercomplexityof itsimplementationwillentailunpredictableconsequenceswhichtheAgenciesarecurrentlynotinaposition tomonitor,foranendwhichisunclear. 2SpecificIssues Theforegoingcriticismnotwithstanding,theICFRrecognisesthattheAgenciesmustimplementsomeform oftherule.Assuch,inthissectionwedirectcommentstosomeofthespecificsoftheproposal,including the exemption for market making, the exemption for trading in US government securities, the extraterritorialconsequencesoftherule,andtheconflictofinterestprovisions. MarketMaking Asmentionedabove,theICFRbelievesthereisaninherentproblemintryingtodifferentiatemarketmaking fromproprietarytrading.Theproposalattemptstodistinguishthemwithquantitativemetricsandhistorical comparative analysis. The six factors the Agencies outline as relevant for distinguishing permitted market making from prohibited proprietary trading seem broadly sensible in principle. But as we have already remarked, it is the practical workings of the proposals which are of concern, and not the logic of the reasoning involved. Question 184 asks whether the six factors are helpful for making the distinction. We wouldsuggestthattheyare. However,onceyoudigfurtherintotheimplementationoftheproposals,itbecomesclearthatbeinghelpful is not sufficient for ensuring that the aims of the rule are met. For instance, the Agencies indicate that assessing whether a trading units risks are being retained in excess of amounts required to provide intermediation services to customers, the Agencies will look at Value at Risk (VaR) measurements, Stress 6|I C F R

 VaR,VaRExceedance,andRiskFactorSensitivities,amongothers.Butifthesemeasuresaredoingthejob they are supposed to, and proprietary activity does not exceed the groups expressed risk appetite, is it necessary to have this further limit on risk taking, based on the Agencies judgment of the level of risk necessaryforbonafidemarketmaking?Ifitisdeemednecessary,thenthiswouldseemtoimplyadistrust ofthefitnessofexistinginstrumentsformanagingrisks,whethertheyaremacroormicroprudential. Ouroverridingconcernwiththeattempttodistinguishmarketmakingfromproprietarytradingisnotthatit wouldnotcaptureproprietarytradingactivity,ifitwerepossibletoimplementeffectively.Rather,itisthat necessarily,byseekingtocapturesuchactivitytherulewillensnareahugeamountoflegitimatebusiness. AppendixBattemptstosetoutguidanceontheissue,includingexplanatoryfactsandcircumstanceswhich might explain a banks activities. The Agencies recognise that there are certain circumstances in which market making activity may appear to be proprietary, including when there are general upward or downward price trends, or marketwide adjustments of risk perceptions, or unanticipated changes in the priceofretainedprincipalpositionsandrisks,andsoforth.TheICFRwouldarguethatitisnottheroleof regulatoryagenciestosecondguesswhetherchangesinpriceorgeneralmarkettrendsareanticipatedor not. Such a set of proposals would seem to favour less insightful firms who hold positions which improve despitetheirignorance,overfirmswiththeskillsandknowledgerequiredtounderstandthemarket.Wedo notseethatincentivisingignoranceinthiswayimprovesthestabilityoffinancialmarkets. As an example, suppose a firm engaged in bona fide market making was to come to the judgment that a significant market disruption was imminent would they effectively be prevented from acting on that businessdecision,whichtheymightarguewasbeingtakenonbehalfofminimisingthelosses(ormaximising the gains) for their clients? Hedging activity to prevent large losses might require the taking of positions which are considered proprietary because they breach historically normal VaR bounds how will the Agenciesdistinguish thesecases?The preventionoflargelossesrelative toonespeerswouldseemto be everybitasproprietaryasthegainingofprofit,inthisrespect. TradinginGovernmentSecurities Inrecentweeks,anumberofseniorfiguresfromarangeofcountrieshaveexpressedconcernsaboutthe exemptionfortradinginUSgovernmentsecurities.TheneedfortheUSfinancialsystemtoprovideliquidity and market making in US government securities is evident. However, the explicit limitation to US government securities, given the size and depth of US markets, discriminates against other government securities in a way that is likely to encourage other governments to enact reciprocal prohibitions for their institutions.GiventheneedforforeignfinancingofUSgovernment,andcurrentaccountdeficits,thiswould havedisastrousconsequences.Moreover,therearenocharacteristicsuniquetoUSgovernmentsecurities, otherthantheneedtofinancetheUSgovernmentdeficit,whichjustifiestheirinclusionorexclusionfrom proprietarytrading.IftheVolckerruleistocontainanexemptionfortradingingovernmentsecurities,this should extend to all liquid, high quality government securities, irrespective of nationality. Banks provide important sources of liquidity to governments, as current world events, notably in the Euro zone, demonstrate. Question 122 asks whether there should be an exemption for trading in the obligations of foreign governments and/or international and multinational development bank. We would argue that given the 7|I C F R

 presence of an exemption for US government securities, it is essential that the proposals contain an exemptionforthesecuritiesofforeigngovernmentsandmultilateraldevelopmentbanks. A number of institutions, such as the Bank of Japan and the Bank of Canada, have publicly and formally expressed their unhappiness with the proposals, and there have been press reports of officials from the EuropeanCommission,theUnitedKingdomandothercountrieshavingexpressedtheirconcernsprivately. TheICFRbelievesthattheseconcernsarelegitimateandhaveabasisinstabilityissues.Assuch,weurgethe AgenciestocooperatewiththeregulatorsoftheG20tofindaformulathatpermitstradingingovernment securities across borders in due proportion to the relative depth, liquidity, and credit quality of those marketsandsecurities 6 . Extraterritoriality __.6(d) of the proposed rule sets out the foreign trading exemption. __.6(d)(1)(i) states that the exemption will operate if banking entity is not directly or indirectly controlled by a banking entity organised under US law. But the definition of control used in the rule, along with the fact that (a) US subsidiariesandbranchesofforeignbanksdonotqualifyfortheexemption,and(b)thefactthattherule statesthatsomeofthestandardswillapplytoanybankwhichtogetherwithitsaffiliatesandsubsidiaries, meetsvariouscriteria,meansthataforeignfirmwhichindirectlycontrolsanybranchintheUnitedStates will be subject to the reporting standards on its entire collective global operations. Further, the relevant agencywouldthenhaveaccesstoallrecordsrelatedtotheenterprisewidecomplianceprogrampertaining to any banking entity that is supervised by the Agency vested with such rulewriting authority. The consequences of this would appear to be exceptionally farreaching. Extraterritoriality of this kind creates unnecessaryburdensforfirmsacrosstheworld,withpotentiallyhighlysignificantcostsforfirmswhichonly incidentallycomeintocontactwiththeUSbankingsystem. Notonlyaretheextraterritorialimplicationsextensiveforfirmswhichwillbesubjecttotheproposedrule, buttheimplicationsforfirmswishingtoavoidtheextraterritorialconsequencesoftherulewillbesimilarly onerous. Any bank wishing to sever ties to the US banking system will quickly discover that this is very difficult; avoiding counterparties subject to the rule will be very difficult, given the extent of interconnectionsininternationalfinancialmarkets. Question 138 asks whether the provisions for whether an activity is conducted solely outside the United Statesareclear.TheICFRbelievesthattheimplicationsoftheseaspectsoftheruleareatbestexceptionally unclear,andatworstaresuchthattheymeritreproposal. WithrespecttononUSbanksoperatingintheUnitedStates,theproposalsstatethatabankwhich,together with its affiliates and subsidiaries, on a worldwide consolidated basis, has trading assets and liabilities (subjecttocertainqualifications)equalorgreaterto$1billion,willberequiredtocomplywiththereporting andrecordkeepingrequirementssetoutinAppendixA.AppendixAthendetailsthatanytradingunitwhich engagesintheexecutionofanycoveredtradingactivitywillberequiredtokeepquantitativerecordsasset
6

WenotespecificallythatcurrentBaselIIrulesencouragefinancialinstitutionstoholdlargeconcentrationsofthe highestyieldingsovereignbondswithoutregardtocreditqualityorliquidity,andtheurgentneedtoaddressthis anomaly.

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 outinthatAppendix.Buttradingunitisthendefinedtoincludealltradingoperations,collectively;and anyotherunitoforganisationspecifiedby[Agency]withrespecttoaparticularbankingentity.Thisappears togofarbeyondwhatmightbeconsideredreasonableintermsofreporting.Itwouldnotbeappropriatefor anonUSglobalbanktohavetoreportonalltradingoperations,collectivelywhenamajorityofthesemay beconductedoutsideoftheUnitedStates. With respect to the foreign trading exemption as delineated in __.6(d)(3), the overview of the proposed rulestatesthatthefollowingfourcriteriaareintendedtoensurethatatransactionexecutedinrelianceon theexemptiondoesnotinvolveU.S.counterparties,U.S.tradingpersonnel,U.S.executionfacilities,orrisks retainedintheUnitedStates: ThetransactionisconductedbyabankingentitythatisnotorganizedunderthelawsoftheUnited StatesorofoneormoreStates; NopartytothetransactionisaresidentoftheUnitedStates; Nopersonnelofthebankingentitythatisdirectlyinvolvedinthetransactionisphysicallylocatedin theUnitedStates; ThetransactionisexecutedwhollyoutsidetheUnitedStates. The ICFR is concerned that the framing of the exemption, along with the definitions of resident of the United States, create undesirable extraterritorial implications. The exemption as framed goes far beyond thatrequiredtorealisetheintentionofthestatute.Inparticular,theguidancedoesnotprovideclarityasto whenatransactionwillbeconsideredtohavebeenexecutedwhollyoutsidetheUnitedStates,anditis unclear that the relationship between trading and execution warrants the inclusion of this clause in the proposal. Further,therequirementthatnopersonnelofthebankingentitythatisdirectlyinvolvedinthetransactionis physicallylocatedintheUnitedStateswouldseemtocapturetheactivitiesofanentiretradingteaminthe event that one member of that team who had, for instance, done preparatory work on a trade, was travellingintheUnitedStatesatthetimethatatradewasexecuted.Sometradescantakeaconsiderable amount of time to put together before execution among teams of people which may change over that periodoftime.Iftheproposalsarenotamendedtoreflectthisthenthereneedstobeafargreaterlevelof detailintheguidanceastohowsuchclauseswillbeinterpreted. ConflictsofInterest Section__.8(a)(1) forbids activities which would involve or result in a material conflict of interest between the covered banking entity and its clients, customers, or counterparties. Section__.8(b) defines material conflict of interest, and paragraphs 8(b)(1)(i) and (ii) and 8(b)(2) outline exemptions for when there has been timely and effective disclosure and opportunity to negate or substantially mitigate the conflict of interest,orforwheretherearereasonablydesignedinformationbarrierstopreventconflictsofinterest frominvolvingorresultinginamateriallyadverseeffectonaclient,customer,orcounterparty. The rule provides that clear, timely, and effective disclosure should provide necessary information, in reasonabledetailsuchthatareasonableclient,customer,orcounterpartymaymeaningfullyunderstand 9|I C F R

 the conflict of interest. It is recognised in the overview of the rule that the difficulties here are elevated whentransactionsarecomplex,highlystructuredoropaque,[involve]illiquidorhardtovalueinstruments orassets,[require]thecoordinationofmultipleinternalgroups[...]or[involve]asignificantasymmetryof informationortransactionaldataamongparticipants.TheICFRwouldemphasisetheimportanceofstrict enforcementofstandardsforclearinformationprovisionadaptedtoboththeproductandtheclient. The ICFRunderstandsfromitsstakeholdersinanumberofjurisdictionsthatthereareproblemswithpointof sale disclosure practices. It is difficult to strike the right balance between caveat emptor and the simple behavioural fact that customers tend not to read large numbers of pages of densely written disclosure information. However, we have found there to be widespread support for making such disclosures significantlysimpler. Therearevaryinglevelsofcomplexityinfinancialmarkets.Forfinancialstabilityreasons,itisimportantthat complexity is understood. Ensuring that parties understand more complex transactions will require those parties to be held to higher than usual standards of governance, and will require more advanced systems andmorecapablestaff.Assuch,webelievethatthethresholdsforrequiringthesehigherstandardstobein placeshouldberelativelylow. The proposed rule would benefit from additional guidance as to what constitutes reasonable detail. Without entering into the details of the US distinction between sophisticated investors and unsophisticated investors, it is clear that certain supposedly very sophisticated customers failed to understandthecomplexitiesofcertainstructuredproductsinthefinancialcrisis,andtheentireprocessof product and conflict disclosure, as well as investor education and financial literacy continue to need significantthought,thoughthisgoeswellbeyondtheremitofthisconsultation. Thepotentialconflictsofinterestthatarisefromabankwhichoperatesasabrokerorprovidesinvestment advicetoclients,butwhichalsoengagesinproprietarytrading,orhassubstantialinterestsinhedgefunds whichareinvolvedinsuchtrading,areplain.However,thisdoesnotmeanthattheyareeasilyclassifiable when potential instances are identified. To take one recent highprofile case the SECs case against Goldman Sachs concerning the ABACUS transaction some have argued that aspects of the business of universal banks here fall into a grey area. 7 Where banks, who may engage in proprietary activity, are acting as brokerdealers, to what extent should they be responsible for informing their clients of the particularsofatrade,andtowhatextentshould clientsbeexpectedtoengageinduediligence?To what extentarebanksownviewsofthelikelyfuturedirectionoftheunderlyingsinatransactionrelevanttothe clientsoneachside?Withcertaintrades,therewillbewinnersandlosers,wheretheopposingsidesofa deal have reached different conclusions about the prospects for a particular instrument or market. These conclusions may be illconsidered, or speculatively formed, but they may be the product of professional judgmentaboutcomplexissueswhicharecontestableandarguablefromanumberofangles.Inthelatter cases,thebrokermaywellhaveitsownview.Shouldbrokersbeunderaregulatoryobligationtodisclose those views? We note that the question of whether brokers should have a fiduciary duty towards their clients remains open. Section 913 of the Dodd Frank Act requires a study into the obligations of brokers, dealersandinvestmentadvisers,withrespecttoretailcustomers,andtheSECsstudypublishedinJanuary 2011recommendsthatbrokerdealersbegivenafiduciarydutytowardssuchinvestorswhendealingwith
7

See,forinstance,AlanMorrison,WilliamWilhelmandRupertYoungerspaperReputationinfinancialmarkets,in InvestinginChange:TheReformofEuropesFinancialMarkets,AFME,2011.

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 securities. It also notes that brokerdealers are generally required to make recommendations that are consistentwiththeinterestsofitscustomer.ButdespitethefactthatthewidelypublicisedABACUScase, which has substantially affected public perceptions of such practices, was a wholesale trade between sophisticated market players, there is no mention in section 913 of fiduciary duties towards nonretail investors. Further, according to the SECs website,there has not even been a date set for the proposal of rulesbasedontherecommendationsofthesection913study. Section 913 states that the offering of proprietary products by brokerdealers will not be, of itself, consideredcontrarytoanyfiduciarydutywhichmaybeplaceduponsuchbrokerdealers,butwillbesubject to disclosure, as well as the notice and consent of customers. This is at the heart of the issue over the ABACUStransactionwhatlevelofdisclosurewasitreasonableforGoldmanSachsclientstoexpect,given thatthefirmwasoperatingasabrokerdealeronthetransaction?Wasthefirmunderanobligation,legal, ethical,orotherwise,toprovideexplicitinformationregardingthePaulsonhedgefundsshortposition,or theinvolvementofthePaulsonfundinselectingthesecuritiesthemselves?Sincethecurrentlawdoesnot putbrokerdealersobligationsonthesamelevelasinvestmentadvisers,thiswillremainagreyarea,and theproposalsunderquestiondonotappeartoaddresstheissue. Question 200 asks whether written disclosure to a client, customer, or counterparty regarding a material conflict of interest should be required. It further asks whether there are circumstances in which oral disclosurewouldsuffice,particularlyincertainfastmovingmarketswithsophisticatedclients,customers, orcounterparties?TheICFRstrugglestoseehowarequirementforwrittendisclosureinallcircumstances wouldbepracticablegiventhepaceoftradingandpositiontakinginfinancialmarkets.Thepossibilityoforal disclosureisaninterestingone,whichperhapsmeritsmoreattention.However,therewouldbeanumberof outstanding issues surrounding the possibility of oral disclosure of conflicts of interest: would all oral disclosureshavetofollowthesameformat?Wouldtheybescripted,forinstance?Whatwouldconstitutean agreementthatanoraldisclosurehadbeenreceivedandunderstood?Wouldsuchagreementshavetobe recorded, and if so, would investors have to keep detailed records of oral disclosures themselves? Would Agencystaffberequiredtokeeptranscripts?Inshort,howwouldanoraldisclosureregimebeenforcedin suchrapidlyevolvingmarkets?Oraldisclosureseemstocarrybenefitsoverwrittendisclosureatfirstglance, but its implementation would clearly entail substantial difficulties, and would perhaps lead to increased opportunitiesforlitigation. Question 201 asks: Should the proposed rule provide further detail regarding the types of conflicts of interest that cannot be addressed and mitigated through disclosure? [...] Should the proposed rule enumerateanexhaustiveornonexhaustivelistofconflictsthatcannotbeaddressedandmitigatedthrough disclosure?TheICFRbelievesthatprovidingalistofsuchconflictswouldbedangerouslyprescriptive,and may introduce further moral hazard problems into the process. Regarding conflicts of interest, it is surely more appropriate to encourage a culture in which conflicts of interest are seen as negative from a banks perspective, and transparency is seen as a desirable part of trusting business relationships, rather than providing a list of circumstances in which a bank can rely on a compliance process for managing such conflicts. 11|I C F R

 RegulatoryLearning Goodregulatorypracticeistorecogniseandmakeexplicitthefactthatregulationwilldevelopovertimein responsetopracticalexperience.Forinstance,theAgenciesrecognitionthatmetricsforassessingwhether underwriting,hedging,andmarketmakingareprohibitedornotarenothardandfast,butareinputsintoa processoflearning,ismatureandtobewelcomed.Furthermore,thereisalwaysthepossibilitythatanew proposalendsuptyingthehandsofaregulatoryorganisationbybeingtooprescriptiveandmakingtheroom formanoeuvretoonarrow.Theproposaldoesseemtomanagethispossibilitywell.TheAgencieswrite: The Agencies intend to take a heuristic approach to implementation in this area that recognises that quantitative measurements can only be usefully identified and employed after a process of substantialpubliccomment,practicalexperience,andrevision. We commend this approach, but would add that a commitment to this approach comes with increased obligationsfortheAgenciesinvolved,intermsofkeepingthemarketawareofdevelopmentsinthoughtand methods, and providing timely and transparent information and guidance about amendments to rules. As we wrote to the Financial Stability Oversight Council in December 2011, the capacity for discretion comes withanobligationfordisclosure.Inthenameoftransparency,theAgenciesshouldsetthemselvesapublicly availablescheduleforthelearningprocess,aswellasasetofcriteriaforassessingthesuccessorfailureof different approaches. This would help to engender a more collegiate approach to regulation in general. However,withrespecttothecurrentproposal,wefearthatevenwiththismatureapproach,itwillsimplybe infeasiblefortheAgenciestoadequatelyexercisetheirjudgmentoversuchavastarrayofactivities,data, andconsequences. Conclusion We should be clear that our concerns with the proposed rule are not simply concerns about compliance burdensorthecostsofanewregulation.Thatanewregulationcreatesaburdenoracostforaregulated entity is not of itself a reason not to carry it through, and good regulation has the potential to improve financial markets. Our concerns are that fundamentally, the current formulation of the Volcker rule increasescomplexity,andthusthescopeforregulatoryarbitrage,ratherthanreducingit. Wewouldliketoemphasizetheimportanceofproportionality.Inthefirstinstance,theICFRhasconcerns aboutthe directionoftheVolckerruleitself,asformulatedintheDoddFrankAct.Werecognisethatthis legislation has already been passed, and that it is not for the Agencies to override the law. However, the difficultiestowhichwehavepointedaresymptomaticofthetextoftheDoddFrankActitself.Theaimofthe lawseemstobetoforcetherestructuringofuniversalbanksinordertoremovepublicsubsidies,whichare theresultoffederaldepositinsuranceschemes,forexcessiverisktaking.ThisistheessenceofPaulVolckers remark,quotedinourgeneralremarksabove.Butlawmakershavebeenpersuadedthatcommercialbanks should be able to perform certain activities which are not easily distinguishable from activities which may proveexcessivelyrisky,suchasmarketmaking,hedging,andunderwriting.Thishasmeantthatarelatively simple principle has been lost to the legal technicalities of framing exemptions and implementing a considerablecomplianceregime. 12|I C F R

 The financial crisis should have been a catalyst for better regulation. Unfortunately, the proposed rule appearstonottohavelearnedthelessonsofpreviousmistakes.Inparticular,theyareoutofproportion,are toocomplex,willhavenegativeconsequencesformarketmakingintheshortterm,areextraterritorial,are inconsistentwithrespecttocertainexemptionssuchasgovernmentsecurities,andfailtoplacethemselves withinthebroadercontextoftheglobalmarketandexistinginternationalstandards.Thecurrentproposals are an excessively complex and unsustainable set of rules, which will not be conducive to the long term stabilityorefficiencyoffinancialmarkets.Wehopethattheywillbereconsidered. Yoursfaithfully, BarbaraRidpath JohnAndrews ChiefExecutive ResearchAnalyst Forandonbehalfof InternationalCentreforFinancialRegulation

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