DEPARTMENT OF THE TREASURY

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    A. Subpart B – Proprietary Trading Restrictions
            1. Section __.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 13.1  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.2  
Section __.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 §§ __.4 through __.6 of the proposed rule.  Section __.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.3
Several commenters expressed concern about the breadth of the ban on proprietary trading.4  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.5  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 mid-size institutions; and could drive risk-taking to the shadow banking system.6  Others urged the Agencies to determine that trading as agent, broker, or custodian for an affiliate was not proprietary trading.7  
Commenters also suggested alternative approaches for defining proprietary trading.  In general, these approaches sought to provide a bright-line definition to provide increased certainty to banking entities8 or make the prohibition easier to apply in practice.9  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.10  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.11  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 financial instruments.12  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.13  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.14  For similar reasons, the Agencies are not adopting a bright-line definition of proprietary trading.15  
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;16 (ii) wider spreads or otherwise increased trading costs;17 (iii) higher borrowing costs for businesses or increased cost of capital;18 and/or (iv) greater market volatility.19  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.20  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.21  
                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.22  
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”).23  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.24  
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”).25  “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 security-based swap dealer to acquire or take positions in connection with its dealing activities (the “dealer trading account”).26  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 security-based swap dealer outside of the United States.27  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).28  
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.29  
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.30  However, a few commenters raised concerns regarding the treatment of arbitrage trading under the proposed rule.31  Several commenters asserted that the proposed definition of trading account was too broad and covered trading not intended to be covered by the statute.32  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.33  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.34  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.35  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.36  A few commenters requested the Agencies define the phrase “short term” in the rule.37
Several commenters argued that the market risk rule should not be referenced as part of the definition of trading account.38  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.39  One commenter thought that the market risk rule trading account was redundant because it includes only positions that have short-term trading intent.40  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.41  
A number of commenters objected to the dealer trading account prong of the definition.42  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.43  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.44  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.45
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,46 or should be simplified.47  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.48  One commenter supported the proposed definition of trading account.49  Other commenters believed that reference to the market-risk 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.50
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.51  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.52  These commenters argued that new definitions in the proposed rule, like trading account, would require foreign banking entities to develop new and complex procedures and expensive systems.53
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,54 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.55  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.56  
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.57  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.58  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.59  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.60  
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.61  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.62  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.63  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.64 
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.”65  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 activities by establishing a clear, bright-line rule for determining that a trade is within the trading account.66  
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 short-term intent.67  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,68 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.69  Activities of a banking entity that are not covered by the dealer prong may, however, be covered by the short-term or market risk rule trading accounts if the purchase or sale satisfies the requirements of §§ __.3(b)(1)(i) or (ii).70
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.71  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.72
In response to commenters’ concerns regarding the application of this prong to banking entities acting as dealers in jurisdictions outside the United States,73 the Agencies continue to believe including the activities of a banking entity engaged in the business of a dealer, swap dealer, or security-based 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.74  
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.75  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 § __.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.76  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.77
                b. Rebuttable Presumption for the Short-Term 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 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,78 or extending the period to 90 days,79 to several months,80 or to one year.81  Some of these commenters argued that specifying an overly short holding period would be contrary to the statute, invite gamesmanship,82 and miss speculative positions held for longer than the specified period.83  Commenters also suggested turning the presumption into a safe harbor84 or into guidance.85  
Other commenters opposed the inclusion of the rebuttable presumption for a number of reasons and requested that it be removed.86  For example, these commenters argued that the presumption had no statutory basis;87 was arbitrary;88 was not supported by data, facts, or analysis;89 would dampen market-making and underwriting activity;90 or did not take into account the nature of trading in different types of securities.91  Some commenters also questioned whether the Agencies would interpret rebuttals of the presumption consistently,92 and stressed the difficulty and costliness of rebutting the presumption,93 such as enhanced documentation or other administrative burdens.94  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.95  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.96 
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.97  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.98  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.99 
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.100  
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.”101  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.102  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.103   
                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.104  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.105  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.106  
The proposal also defined a number of other terms used in the definition of covered financial position, including commodity, derivative, loan, and security.107  These terms were generally defined by reference to the federal securities laws or the Commodity Exchange Act because these existing definitions are generally well-understood 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 security-based 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.108  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);109 (iii) any agreement, contract, or transaction in foreign currency described in section 2(c)(2)(C)(i) of the Commodity Exchange Act;110 (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;111 and (v) any transactions authorized under section 19 of the Commodity Exchange Act.112  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.113  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.114  One commenter argued that the proposed definition of covered financial position was effective and recommended that the definition should not be expanded.115  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.116  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.117
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.118  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.119  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.120
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.121  This commenter alleged that these instruments are not derivatives but 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.122
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.123  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.124
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;125 (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.126  The final rule excludes from the definition of financial instrument: (i) a loan;127 (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.128  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 transactions129 or loans130, 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.131  Similarly, while some commenters requested that certain other instruments, such as foreign exchange swaps and forwards, be excluded from the definition of financial instrument,132 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. 133  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,134 the CFTC and SEC have subsequently finalized those definitions after receiving extensive public comment on the rulemakings.135  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 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 non-proprietary 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.
                            1. 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,136 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.137  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.138  
Several commenters expressed support for these exclusions and requested that the Agencies expand them.139  For example, one commenter requested clarification that all types of repurchase transactions qualify for the exclusion.140  Some commenters requested expanding this exclusion to cover all positions financed by, or transactions related to, repurchase and reverse repurchase agreements.141  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.142  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.143  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.144  
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.145  Some of these commenters argued that repurchase agreements could be used for prohibited proprietary trading146 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.147  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.148  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.149  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.150
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 trading.151  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,152 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.153  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.154  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.155  
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.156  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.157
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.158  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.159  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.160  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,161 and would limit banking entities’ ability to manage liquidity.162  
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.163  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.164  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.165  
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.166  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.167  Commenters also urged that the final rule not prohibit interaffiliate transactions essential to the ALM function.168
In contrast, other commenters supported the liquidity management exclusion criteria169 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.170  Other commenters argued that the exclusion for liquidity management should be eliminated.171  One commenter argued that there was no need to provide a special exemption for liquidity management or ALM activities given the exemptions for trading in government obligations and risk-mitigating hedging activities.172  
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.173
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.174  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.175  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.176  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 asset-liability 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.177  
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 short-term 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.178  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 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.179  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 short-term price movements.180
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.181  One commenter recommended expanding the exclusion to non-U.S. central counterparties 182  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).183  
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.184  In response to comments,185 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,186 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.187  These commenters noted that the proposed definition of “trading account” provides an exclusion for positions taken by registered derivatives clearing organizations and registered clearing agencies188 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”).189
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.190  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;191 (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;192 and (v) imposing certain obligations on clearing members upon exhaustion of a guaranty fund.193 
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.194  Some commenters suggested alternative avenues for permitting such clearing-related activity under the rules.195  Commenters argued that such clearing-related 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.196
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 self-referencing 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)197 and trade crossing, a mechanism employed by 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.198
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 clearing-related activities provide important benefits to the financial system.199  In particular, central clearing reduces counterparty credit risk,200 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.201  
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.202  “Excluded clearing activities” is defined in the rule to identify particular core clearing-related activities, many of which were raised by commenters.203  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;204 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.205    
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,206 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.207  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.208  In certain circumstances, SEC-registered broker-dealers are required to take such action under SEC rules.209  In addition, buy-in procedures of a clearing agency, securities exchange, or national securities association may require a banking entity to deliver securities if a party with a fail to receive position takes certain action.210  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.211  Providing a limited exclusion for this activity will avoid the potential for SEC-registered broker-dealers 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.212  A banking entity may also be obligated to purchase or sell a financial instrument in connection with a judicial or arbitration proceeding.213  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.214  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.215  
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.216   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.217
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, stock-bonus, 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.218  Commenters argued that acquiring and 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.219
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.220  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.221  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.222  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 __.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
                            1. 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.223
Section __.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 § __.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 risk-taking.224  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 part of, or mischaracterized as, underwriting activity.225
                            1. Comments on proposed underwriting exemption
As a general matter, a few commenters expressed overall support for the proposed underwriting exemption.226  Some commenters indicated that the proposed exemption is too narrow and may negatively impact capital markets.227  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.228  More specifically, commenters recommended that the Agencies: (i) provide a safe harbor for low risk, standard underwritings;229 (ii) better incorporate the statutory limitations on high-risk activity or conflicts of interest;230 (iii) prohibit banking entities from underwriting illiquid securities;231 (iv) prohibit banking entities from participating in private placements;232 (v) place greater emphasis on adequate internal compliance and risk management procedures;233 or (vi) make the exemption as broad as possible.234
                            2. 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 capital-raising 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.235
    • 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.236  
    • 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:  
        ◦ 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.237
        ◦ 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.238
        ◦ 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: 
            ▪ The products, instruments, or exposures each trading desk may purchase, sell, or manage as part of its underwriting activities; 
            ▪ 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; 
            ▪ Internal controls and ongoing monitoring and analysis of each trading desk’s compliance with its limits; and 
            ▪ 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 increase to a trading desk’s limit(s), and independent review of such demonstrable analysis and approval.239
        ◦ The compensation arrangements of persons performing the banking entity’s underwriting activities are designed not to reward or incentivize prohibited proprietary trading.240
        ◦ The banking entity is licensed or registered to engage in the activity described in the underwriting exemption in accordance with applicable law.241
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.242  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.243  
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,244 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.245  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.246  
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.247  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.248
Underwriters play an important role in facilitating issuers’ access to funding, and thus underwriters are important to the capital formation process and economic growth.249  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
                            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
	Section __.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.250  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.251  
    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.252  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.”253  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.254  The Agencies noted that “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.255
    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.256  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.257  
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 capital-raising;
    • 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 post-issuance secondary market and to facilitate price discovery.258
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.259
    iii. Proposed requirement that the covered financial position be a security
Pursuant to § __.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.260  The proposal stated that this requirement was meant to reflect the common usage and understanding of the term “underwriting.”261  It was noted, however, that a derivative or commodity future transaction may be otherwise permitted under another exemption (e.g., the exemptions for market making-related or risk-mitigating hedging activities).262
                                a. 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 § __.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-by-transaction basis.  These commenters indicated that such an approach would be overly burdensome.263
    i. Definition of “distribution”
Several commenters stated that the proposed definition of “distribution” is too narrow,264 while one commenter stated that the proposed definition is too broad.265  Commenters who viewed the proposed definition as too narrow stated that it may exclude important capital-raising and financing transactions that do not appear to involve “special selling efforts and selling methods” or “magnitude.”266  In particular, these commenters stated that the proposed definition of “distribution” may preclude a banking entity from participating in commercial paper issuances,267 bridge loans,268 “at-the-market” offerings or “dribble out” programs conducted off issuer shelf registrations,269 offerings in response to reverse inquiries,270 offerings through an automated execution system,271 small private offerings,272 or selling security holders’ sales of securities of issuers with large market capitalizations that are executed as underwriting transactions in the normal course.273  
Several commenters suggested that the proposed definition be modified to include some or all of these types of offerings.274  For example, two commenters requested that the definition explicitly include all offerings of securities by an issuer.275  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.276  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 so-called “section 4(1½)” of the Securities Act, as well as transactions on behalf of selling security holders.277  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.278  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.279  
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.280
    ii. Definition of “underwriter”
Several commenters stated that the proposed definition of “underwriter” is too narrow.281  Other commenters, however, stated that the proposed definition is too broad, particularly due to the proposed inclusion of selling group members.282  
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.283  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.284  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.285  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).286
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.287
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.288  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.289
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, 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.290
    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.291  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.292  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,293 may reduce future innovation in the capital-raising process,294 and could create market disruptions.295 
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.296  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;297 (ii) creating a stabilizing bid;298 (iii) acquiring positions via overallotments299 or trading in the market to close out short positions in connection with an overallotment option or in connection with other stabilization activities;300 (iv) using call spread options in a convertible debt offering to mitigate dilution of existing shareholders;301 (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;302 (vi) purchasing debt securities of comparable issuers as a price discovery mechanism in connection with underwriting a new debt security;303 (vii) hedging the underwriter’s exposure to a derivative strategy engaged in with an issuer;304 (viii) organizing and assembling a resecuritized product, including, for example, sourcing bond collateral over a period of time in anticipation of issuing new securities;305 and (ix) selling a security to an intermediate entity as part of the creation of certain structured products.306
                                b. 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.307  This requirement is substantially similar to the proposed rule,308  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,309 the Agencies are modifying 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 § __.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.310  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.311  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.312  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.313
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.314  As proposed, the Agencies will rely on the same factors considered under Regulation M to analyze the presence of special selling efforts and selling methods.315  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.316  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 exemptions317 and, to the extent the commercial paper being offered is a security, commercial paper offerings that involve the underwriter receiving special compensation.318
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.319  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.320  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),321 bought deals,322 at the market offerings,323 debt offerings, asset-backed security offerings, initial public offerings, and other registered offerings.  An offering can be a distribution for purposes of either § __.4(a)(3)(i) or § __.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.324  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.325
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 market-making 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.326  
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 to participate in the distribution.327  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.328  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 § __.4(a)(4) as part of a distribution of securities:
    • Assisting an issuer in capital-raising;
    • 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 post-issuance secondary market and to facilitate price discovery.329 
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.330  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.331  A “selling security holder” is defined as “any person, other than an issuer, on whose behalf a distribution is made.”332  This definition is consistent with the definition of “selling security holder” found in the SEC’s Regulation M.333
    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 § __.4(a)(2)(iii) of the proposed rule, which commenters noted was not included in the statute’s underwriting exemption.334  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.335  
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 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,336 syndicate shorting and aftermarket short covering,337 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,338 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).339  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,340 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.341  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.342  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.343  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.344  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,345 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.346  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, § __.4(a)(2)(v) of the proposed rule required that the underwriting activities of the banking entity with respect to the covered financial position be designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties.347
                                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.”348  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.349  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.350  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.”351    
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.352  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,”353 rights offerings,354 and fixed-income offerings.355  A few commenters noted that similar scenarios can arise in the case of an AP creating more shares of an ETF than it can sell356 and bridge loans.357  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.358   
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.359  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.360  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.361  One of these commenters recommended the Agencies use a metric to monitor the size of residual positions retained by an underwriter,362 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.363  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.364
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.365  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.366 
In addition, in response to a question in the proposal, one commenter expressed the view that the rule should not require documentation with respect to residual positions held by an underwriter.367  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.368  
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.369  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.370  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.371
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.372  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.373
                                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.374  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.375  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.376  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.377  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 book-building 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.378  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.379  
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-than-expected purchaser demand at a given price.380  An unsold allotment is, however, subject to the requirement to make reasonable efforts to sell or otherwise reduce the underwriting position.381  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.382    
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 capital383 or would negatively impact certain types of securities offerings (e.g., bought deals, rights offerings, and fixed-income offerings).384  Other commenters, however, expressed concern that the proposed exemption would allow a banking entity to retain a portion of a distribution for speculative purposes.385  
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.386  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.387  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.388  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 hedging exemption in § __.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.389  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.390  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.391  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 __.4(a)(2)(i) of the proposed exemption required a banking entity to establish an internal compliance program, as required by § __.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.392  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.393
                                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 § __.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 testing394 identifying and addressing: (i) the products, instruments or exposures each trading desk may purchase, sell, or manage as part of its underwriting activities;395 (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;396 (iii) internal controls and ongoing monitoring and analysis of each trading desk’s compliance with its limits;397 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.398  
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.399  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 § __.4(a) of the final rule.  Each of the 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 market-making exemption, except that the Agencies are requiring more detailed risk management procedures in the market-making exemption due to the nature of that activity.400  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.401
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.402  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.403  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 § __.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.404 
                            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.405  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.406
                                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.407  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.408  Finally, one commenter suggested that the term “designed” should be removed from this provision.409
                                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 designed not to reward or incentivize prohibited proprietary trading.410  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 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.411  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.412  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.413  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 __.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.414  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 § __.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 § __.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.415
	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.416  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 § __.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 businesses.417  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 § __.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.418  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.419  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.420
                                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.421  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.422  
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.423  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.424  
To strengthen the proposed requirement, one commenter requested that the terms “designed” and “primarily” be removed and replaced by the word “solely.”425  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 pre-existing market and a foreseeable market price.426
                                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 § __.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 activity427 or may impact primary dealer activities.428  At the same time, the final rule continues to include provisions that focus on whether an underwriter is generating underwriting-related 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.429  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 pre-existing market and a foreseeable market price, as suggested by two commenters.430  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.431  Further, one commenter recommended a revenue requirement directed at securitization activities to prevent banking entities from accumulating large and risky positions with significant market exposure.432  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.433
            3. Section __.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 market-making 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 making-related 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.434  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
                            1. 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.435
Section __.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 § __.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.436  
                            1. Comments on the proposed market-making 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 market-making 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 market-making 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 making-related 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 market-making 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 market-making services are provided in those markets and asset classes.437  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).438  Several commenters stated that the proposed exemption would create too much uncertainty regarding compliance439 and, further, may have a chilling effect on banking entities’ market making-related activities.440  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.441  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 making-related activities.442
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.443  Many of these commenters suggested that the exemption should only be available for traditional market-making activity in relatively safe, “plain vanilla” instruments.444  Two commenters represented that the proposed exemption would have little to no impact on banking entities’ current market making-related services.445  
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.446  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.447  
Other commenters were of the view that it is possible to differentiate between prohibited proprietary trading and permitted market making-related activity.448  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.449  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.450
	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.451  Commenters appeared to attribute these concerns to language in the proposed exemption referring to a “purchase or sale of a [financial instrument]”452 or to language in Appendix B indicating that the Agencies may assess certain factors and criteria at different levels, including a “single significant transaction.”453  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.454  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.455  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.456  One commenter elaborated on this point by stating that “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.”457  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.458  Two commenters suggested that the requirements in the market-making exemption be applied at the portfolio level rather than the trade level.459
	Moreover, commenters also set forth their views on the organizational level at which the requirements of the proposed market-making exemption should apply.460  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 unit461 or at each trading unit.462  
Several commenters suggested alternative or additive means of implementing the statutory exemption for market making-related activity.463  Commenters’ recommended approaches varied, but a number of commenters requested approaches involving one or more of the following elements: (i) safe harbors,464 bright lines,465 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);466 (ii) a focus on metrics or other objective factors;467 (iii) guidance on permitted market making-related activity, rather than rule requirements;468 (iv) risk management structures and/or risk limits;469 (v) adding a new customer-facing criterion or focusing on client-related activities;470 (vi) capital and liquidity requirements;471 (vii) development of individualized plans for each banking entity, in coordination with regulators;472 (viii) ring fencing affiliates engaged in market making-related activity;473 (ix) margin requirements;474 (x) a compensation-focused approach;475 (xi) permitting all swap dealing activity;476 (xii) additional provisions regarding material conflicts of interest and high-risk assets and trading strategies;477 and/or (xiii) making the exemption as broad as possible under the statute.478
                                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 making-related activity.  Many of these commenters represented that, as a result, the proposed exemption would likely result in reduced liquidity,479 wider bid-ask spreads,480 increased market volatility,481 reduced price discovery or price transparency,482 increased costs of raising capital or higher financing costs,483 greater costs for investors or consumers,484 and slower execution times.485  Some commenters expressed particular concern about potential impacts on institutional investors (e.g., mutual funds and pension funds)486 or on small or midsized companies.487  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.488  
A few commenters expressed the view that reduced liquidity would not necessarily be a negative result.489  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.490  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.491  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.492  
Some commenters stated that it is unlikely the proposed rule would result in the negative market impacts identified above, such as reduced market liquidity.493  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 activity or other trading activity.494  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.495  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.496  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.497 
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.498 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.499  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.500  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.501  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.502  
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,503 including trading for price discovery purposes or to test market depth;504 (ii) inventory management;505 (iii) block positioning activity;506 (iv) acting as an authorized participant or market maker in ETFs;507 (v) arbitrage or other activities that promote price transparency and liquidity;508 (vi) primary dealer activity;509 (vii) market making in futures and options;510 (viii) market making in new or bespoke products or customized hedging contracts;511 and (ix) inter-affiliate transactions.512  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.513  Some commenters stated that no other activities should be considered permitted market making-related activity under the rule.514  In addition, a few commenters requested clarification that high-frequency trading would not qualify for the market-making exemption.515  
                            2. 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 a given marketplace, certain characteristics of a market-making business may differ among markets and asset classes.516  The final rule is intended to account for these differences to allow banking entities to continue to engage in market making-related 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.517  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 “market-maker 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.518
    • 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.519  
    • 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:
        ◦ 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;520
        ◦ 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;521
        ◦ The banking entity has established and implements, maintains, and enforces an internal compliance program that is reasonably designed to ensure its compliance with the market-making exemption, including reasonably designed written policies and procedures, internal controls, analysis, and independent testing identifying and addressing: 
            ▪ The financial instruments each trading desk stands ready to purchase and sell in accordance with § __.4(b)(2)(i) of the final rule; 
            ▪ 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;522 
            ▪ 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;  
            ▪ Internal controls and ongoing monitoring and analysis of each trading desk’s compliance with its limits; and 
            ▪ Authorization procedures, including escalation procedures that 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;523  
        ◦ 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;524
        ◦ The compensation arrangements of persons performing market making-related activities are designed not to reward or incentivize prohibited proprietary trading;525 and
        ◦ The banking entity is licensed or registered to engage in market making-related activities in accordance with applicable law.526
    • The use of quantitative measurements to highlight activities that warrant further review for compliance with the exemption.527  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 market-making exemption, the Agencies closely considered the various alternative approaches suggested by commenters.528  However, like the proposed approach, the final market-making exemption continues to adhere to the statutory mandate that provides for an exemption to the prohibition on proprietary trading for market making-related 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 statute529 and strikes an appropriate balance between commenters’ desire for both clarity and flexibility.  For example, while a bright-line 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.530  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.531  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.532  
Some commenters suggested an approach to implementing the market-making exemption that would focus on metrics or other objective factors.533  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.534  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.535  
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,536 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.537  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 commenters.538  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 market-making exemption, instead of a separate appendix.539  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.540  However, commenters disagreed about whether reduced liquidity would be beneficial or detrimental to the market, or if any such reductions would even materialize.541  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.542  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.543  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.544  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 liquidity-based volatility is not diversifiable, investors will require a risk premium for holding liquidity risk, increasing the cost of capital.545  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.546  Volume in these 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.547  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 front-run institutional investors.548  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 market-making 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.549  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 market-making 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.550  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 market-making 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 market-making 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 making-related activities.  Banking entities will incur certain compliance costs in connection with their market making-related 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 market-making activities if the final rule should cause banking entities to reduce their market-making activities.551  The Agencies note that prior to the Gramm-Leach-Bliley Act of 1999, market-making services were more commonly provided by non-bank-affiliated broker-dealers 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-bank-affiliated 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 market-making 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 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 currently-available market-making services.552  
                c. Detailed Explanation of the Market-Making Exemption
                            1. Requirement to routinely stand ready to purchase and sell
                                a. Proposed requirement to hold self out
Section __.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.553  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.554
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.555  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 exchange-traded instruments, should generally include: (i) making continuous, two-sided 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.556  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;557 (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.558  
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 § __.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;559 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.560 
                                b. Comments on the proposed requirement to hold self out
	Commenters raised many issues regarding § __.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.561  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.562  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 two-sided market, or in customer-driven, structured transactions.563  In addition, a few commenters expressed specific concern about how this requirement would impact more limited market-making activity conducted by banks.564  
	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.565  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.566  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.567  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.568  
	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 two-sided, quoting.569  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.570  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;571 (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;572 or (iii) a historical test of market-making activity, with compliance judged on the basis of actual trades.573  Finally, two commenters stated that this requirement should be moved to Appendix B of the rule,574 which, according to one of these commenters, would provide the Agencies greater flexibility to consider the facts and circumstances of a particular activity.575	  
	Other commenters took the view that the proposed requirement was too permissive.576  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.577  Some commenters suggested the Agencies place greater restrictions on a banking entity’s ability to rely on the market-making 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.578  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);579 relation to the last financial crisis;580 lack of important benefits to the real economy;581 similarity to prohibited proprietary trading;582 and inconsistency with the statute’s requirements that market making-related activity must be “designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties” and must not result in a material exposure to high-risk assets or high-risk trading strategies.583  
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.584  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 157.585  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.586  In addition, a few commenters suggested that banking entities be subject to additional capital charges for market making in illiquid products.587  Another commenter stated that the Agencies should require all market making-related activity to be conducted on a multilateral organized electronic trading platform or exchange to make it possible to monitor and confirm certain trading data.588  Two commenters emphasized that their recommended restrictions on market making in illiquid markets should not prohibit banking entities from making markets in corporate bonds.589
    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.590  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.591  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.592  
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.593  
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.594 
The preamble to the proposed rule also provided certain proposed indicia of bona fide market making-related activity in less liquid markets.595  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.596  
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.597  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 requirement.598  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.599 
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.600  Several commenters stated that trading only by appointment should not qualify as market making for purposes of the proposed rule.601  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.602
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.603  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.604  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).605
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.606  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.607  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.608
    ii. Treatment of block positioning activity
The proposal provided that the activity described in § __.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.609
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).610  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).611  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.612  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.613
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.614  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 market-making 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.615  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.616  
    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 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.”617  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.618   
In addition, two commenters expressed concern that the proposal’s language would effectively require a banking entity to engage in impermissible front running.619  One of these commenters indicated that the Agencies should not restrict anticipatory trading to such a short time period.620  To the contrary, the other commenter stated that anticipatory accumulation of inventory should be considered to be prohibited proprietary trading.621  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.622  Several commenters recommended that the language be eliminated623 or modified624 to address the concerns discussed above.
    iv. High-frequency trading
A few commenters stated that high-frequency trading should be considered prohibited proprietary trading under the rule, not permitted market making-related activity.625  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.626  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.627
                                c. Final requirement to routinely stand ready to purchase and sell
	 Section __.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 market-making exemption has some similarity to the requirement to hold oneself out in § __.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.628  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.”629  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 to meet or impractical in the context of many markets, especially less liquid markets.630  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,631 the Agencies note that it is not directly based on an existing definition of market making.632  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 market-making 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.633    
The Agencies received few comments regarding the organizational level at which the requirements of the market-making exemption should apply, and many of the commenters that addressed this issue did not describe their suggested approach in detail.634  One commenter suggested that the market-making 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.”635  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.).636  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.637  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.638  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 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.639  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-by-trade 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.640  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 Euro-denominated 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.641  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.642
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 market-making 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.  
    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].”643  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.644  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.”645 
The Agencies are adopting an approach that focuses on both a trading desk’s financial exposure and market-maker 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.646  
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 market-maker 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 market-maker 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.647  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.648 
Under the final rule, the term market-maker 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.649  Those financial instruments in which a trading desk acts as market maker must be identified in the trading desk’s compliance program under § __.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.650  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.651  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 making-related 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 making-related activities is best determined by 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 market-maker 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 market-maker 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 market-maker 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.652  
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.653  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.654  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,655 and a banking entity should be able to demonstrate that the financial exposure of a trading desk is related to its market-making 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.”656  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 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.657  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.658  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 SEC-registered 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.659  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 § __.4(b)(2)(iii) of the final rule; and (ii) the resulting risk-mitigating 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.660  It may not rely on the market-making exemption under these circumstances.  If a trading desk engages in a risk-mitigating 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.661  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. 
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 § __.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-by-trade 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 market-maker inventory.662  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 customer-facing are nevertheless integral to market making and financial intermediation.663  The Agencies understand that the risk-reducing effects of combining large diverse portfolios could, in certain instances, mask otherwise prohibited proprietary trading.664  However, the Agencies do not believe that taking a transaction-by-transaction 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 market-making 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.665  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.666  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 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.667  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.668  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.669   
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.670  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.671  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 § __.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 market-maker 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.672
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 own account in commercially reasonable amounts and throughout market cycles.673  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.674  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.675  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.676  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.677  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 market-maker inventory, including the near term customer demand requirement678 and the need to have certain risk and inventory limits.679  
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 market-making 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 market-making exemption in the manner requested by these commenters.680  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,681 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 making-related 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,682 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.683  The Agencies believe this approach is generally consistent with the comments the Agencies received on this issue.684  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.685  
                            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.686  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 purported market making-related activities.687
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 market-making exemption.688  
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 non-directional 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.689
                                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.690  Some commenters expressed general support for this requirement.691  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.692  Several other commenters expressed concern that the proposed requirement is too restrictive693 because, for example, it may impede a market maker’s ability to build or retain inventory694 or may impact a market maker’s willingness to engage in block trading.695  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.696  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.697  
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.698  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.699  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.700
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),701 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.702  For example, many of these commenters stated that market makers may need to enter market or marketable limit orders to: (i) build or reduce inventory;703 (ii) address order imbalances on an exchange by, for example, using market orders to lessen volatility and restore pricing equilibrium; (iii) hedge market-making positions; (iv) create markets;704 (v) test the depth of the markets; (vi) ensure that ETFs, American depositary receipts (“ADRs”), options, and other instruments remain appropriately priced;705 and (vii) respond to movements in prices in the markets.706  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.707
A few commenters also addressed the proposed use of a market maker’s exchange registration status as part of the analysis.708  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.709  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.710  
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.711  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.712  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 market-making character of the relevant trading activity.713
    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.714  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.715  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.716  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.717  Many commenters requested certain modifications to the proposed requirement to limit its impact on market maker inventory.718  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.719  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.720  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.721
    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.722  For example, two commenters suggested ways in which a banking entity could predict near term customer demand.723  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.724  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.725
Some commenters, however, emphasized that reasonably expected near term customer demand cannot always be accurately predicted.726  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.727  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.728
    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.729  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.730  Commenters expressed varying views on the proposed interpretations in the proposal and on whether these terms should be defined in the final rule.731 
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.732  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.733 
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.734  Other commenters indicated that further definition of these terms would be appropriate.735  Some of these commenters suggested that there should be greater limitations on who can be considered a “customer” under the rule.736  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.737  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.738  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;739 or (ii) engages in transactions driven by algorithmic trading strategies.740  Three commenters requested more permissive definitions of these terms.741  According to one of these commenters, because these terms are listed in the disjunctive in the statute, the broadest term – a “counterparty” – should prevail.742   
    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.743  As a general matter, commenters attributed these concerns to statements in proposed Appendix B744 or to the Customer-Facing Trade Ratio metric in proposed Appendix A.745  A number of commenters requested that the rule be modified to clearly recognize interdealer trading as a component of permitted market making-related activity746 and suggested ways in which this could be accomplished (e.g., through a definition of “customer” or “counterparty”).747   
	Commenters emphasized that interdealer trading provides certain market benefits, including increased market liquidity;748 more efficient matching of customer order flow;749 greater hedging options to reduce risks;750 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;751 and general price discovery among dealers.752  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.753  Some commenters stated that a banking entity would be less able or willing to provide market-making services to customers if it could not engage in interdealer trading.754 
	As noted above, a few commenters stated that market makers may use interdealer trading for price discovery purposes.755  Some commenters separately discussed the importance of this activity and requested that, when conducted in connection with market-making activity, trading for price discovery be considered permitted market making-related activity under the rule.756  Commenters indicated that price discovery-related trading results in certain market benefits, including enhancing the accuracy of prices for customers,757 increasing price efficiency, preventing market instability,758 improving market liquidity, and reducing overall costs for market participants.759  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 market-making activity or widening of spreads to offset the risk.760  One commenter further requested that trading to test market depth likewise be permitted under the market-making exemption.761  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.762
    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.763  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.764  A few commenters cited legislative history in support of allowing banking entities to hold and manage inventory in connection with market making-related activities.765  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;766 accommodating customer transactions more quickly and at favorable prices; reducing near term price volatility (in the case of selling a customer block position);767 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);768 ensuring that markets continue to have sufficient liquidity;769 fostering a two-way market; and establishing a market-making presence.770  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)771 and in anticipation of an index rebalance.772
	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.773  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.774  One commenter represented that a trading unit’s inventory management practices could be monitored with the Inventory Risk Turnover metric, in conjunction with other metrics.775     
    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.776  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;777 (ii) trading to maintain price alignment between the ETF shares and the underlying components;778 (iii) traditional market-making activity;779 (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;780 (v) “create to lend” transactions, where an AP enters a creation transaction with the ETF issuer and lends the ETF shares to an investor;781 and (vi) hedging.782  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.783  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.784   
	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,785 the proposed source of revenue requirement,786 and language in the proposal regarding arbitrage trading.787  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.788  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.789  To permit banking entities to act as APs, two commenters suggested that trading in the capacity of an AP should be deemed permitted market making-related activity, regardless of whether the AP is acting as a traditional market maker.790  
    viii. Arbitrage or other activities that promote price transparency and liquidity
	 In response to a question in the proposal,791 a number of commenters stated that certain types of arbitrage activity should be permitted under the market-making exemption.792  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)793 or to the extent that demand is predicated on specific price relationships between instruments (e.g., ETFs, ADRs) that market makers must maintain.794  Similarly, another commenter suggested that arbitrage activity that aligns prices should be permitted, such as index arbitrage, ETF arbitrage, and event arbitrage.795  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.796  Commenters stated that arbitrage trading provides certain market benefits, including enhanced price transparency,797 increased market efficiency,798 greater market liquidity,799 and general benefits to customers.800  A few commenters noted that certain types of hedging activity may appear to have characteristics of arbitrage trading.801	  
	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 market-making 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.802  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.803  
	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.804  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.805
    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.806  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,807 and bidding on each issuance of the relevant jurisdiction’s sovereign debt.808  Commenters expressed concern that a banking entity’s trading activity as primary dealer may not comply with the proposed near term customer demand requirement809 or the proposed source of revenue requirement.810  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.811  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.812
    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.813  Many of these commenters emphasized the role such transactions play in helping customers hedge the unique risks they face.814  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.815  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.816 
	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 customized derivatives.817  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 market-making 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.818  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.819
                                c. Final near term customer demand requirement
	Consistent with the statute, § __.4(b)(2)(ii) of the final rule’s market-making 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.820  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.821  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 market-maker 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 making-related 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.822        
To clarify the application of this standard in response to comments,823 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),824 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.825  
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.826  In addition, as discussed below, this requirement is not intended to impede a trading desk’s ability to engage in 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.827  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 market-maker 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.828  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 market-maker inventory would not be consistent with permitted market-making 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 market-making 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). 829  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.830  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,831 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.”832  However, for purposes of the analysis supporting the market-maker inventory held to meet the reasonably expected near-term demands of clients, customer 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 § __.20(d)(1),833 unless the 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.834 
 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.835  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.836  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 trade837 or preventing any banking entity from being a client, customer, or counterparty.838  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 market-making exemption as well as the underwriting exemption.839  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 making-related 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.840  
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 (or equivalent structure).841  For example, an AP may buy ETF shares from market participants who would like to redeem those shares for cash or a basket of instruments upon which the ETF is based.  To provide this service, the AP may in turn redeem these shares from the ETF itself.  Similarly, an AP may receive cash or financial instruments from a market participant seeking to purchase ETF shares, in which case the AP may use that cash or set of financial instruments to create shares from the ETF.  In either case, for the purpose of the market-making exemption, such market participants as well as the ETF itself would be considered clients, customers, or counterparties of the AP.842  The inventory of ETF shares or underlying instruments held by the AP can therefore be evaluated under the criteria of the market-making exemption, such as how these holdings relate to reasonably expected near term customer demand.843  These criteria can be similarly applied to other activities of the AP, such as building inventory to “seed” a new ETF or engaging in ETF-loan related transactions.844 The Agencies recognize that banking entities currently conduct a substantial amount of AP creation and redemption activity in the ETF market and, thus, if the rule were to prevent or restrict a banking entity from acting as an AP for an ETF, then the rule would impact the functioning of the ETF market.845
Some firms, whether or not an AP in a given ETF, may also actively engage in buying and selling shares of an ETF and its underlying instruments in the market to maintain price continuity between the ETF and its underlying instruments, which are exchangeable for one another.  Sometimes these firms will register as market makers on an exchange for a given ETF, but other times they may not register as market maker.  Regardless of whether or not the firm is registered as a market maker on any given exchange, this activity not only provides liquidity for ETFs, but also, and very importantly, helps keep the market price of an ETF in line with the NAV of the fund.  The market-making exemption can be used to evaluate trading that is intended to maintain price continuity between these exchangeable instruments by considering how the firm quotes, maintains risk and exposure limits, manages its inventory and risk, and, in the case of APs, exercises its ability to create and redeem shares from the fund.  Because customers take positions in ETFs with an expectation that the price relationship will be maintained, such trading can be considered to be market making-related activity.846  
After considering comments, the Agencies continue to take the view that a trading desk would not qualify for the market-making exemption if it is wholly or principally engaged in arbitrage trading or other trading that is not in response to, or driven by, the demands of clients, customers, or counterparties.847  The Agencies believe this activity, which is not in response to or driven by customer demand, is inconsistent with the Congressional intent that market making-related activity be designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties.  For example, a trading desk would not be permitted to engage in general statistical arbitrage trading between instruments that have some degree of correlation but where neither instrument has the capability of being exchanged, converted, or exercised for or into the other instrument.  A trading desk may, however, act as market maker to a customer engaged in a statistical arbitrage trading strategy.  Furthermore as suggested by some commenters,848 trading activity used by a market maker to maintain a price relationship that is expected and relied upon by clients, customers, and counterparties is permitted as it is related to the demands of clients, customers, or counterparties because the relevant instrument has the capability of being exchanged, converted, or exercised for or into another instrument.849
	The Agencies recognize that a trading desk, in anticipating and responding to customer needs, may engage in interdealer trading as part of its inventory management activities and that interdealer trading provides certain market benefits, such as more efficient matching of customer order flow, greater hedging options to reduce risk, and enhanced ability to accumulate or exit customer-related positions.850  The final rule does not prohibit a trading desk from using the market-making exemption to engage in interdealer trading that is consistent with and related to facilitating permissible trading with the trading desk’s clients, customers, or counterparties.851  However, in determining the reasonably expected near term demands of clients, customers, or counterparties, a trading desk generally may not account for the expected trading interests of a trading desk or other organizational unit of an entity with aggregate trading assets and liabilities of $50 billion or greater (except if the trading desk documents why and how a particular trading desk or other organizational unit at such a firm should be considered a customer or the trading desk or conduct market-making activity anonymously on an exchange or similar trading facility that permits trading on behalf of a broad range of market participants).852    
A trading desk may engage in interdealer trading to: establish or acquire a position to meet the reasonably expected near term demands of its clients, customers, or counterparties, including current demand; unwind or sell positions acquired from clients, customers, or counterparties; or engage in risk-mitigating or inventory management transactions.853  The Agencies believe that allowing a trading desk to continue to engage in customer-related interdealer trading is appropriate because it can help a trading desk appropriately manage its inventory and risk levels and can effectively allow clients, customers, or counterparties to access a larger pool of liquidity.  While the Agencies recognize that effective intermediation of client, customer, or counterparty trading may require a trading desk to engage in a certain amount of interdealer trading, this is an activity that will bear some scrutiny by the Agencies and should be monitored by banking entities to ensure it reflects market-making activities and not impermissible proprietary trading.      
    ii. Impact of the liquidity, maturity, and depth of the market on the analysis
Several commenters expressed concern about the potential impact of the proposed near term demand requirement on market making in less liquid markets and requested that the Agencies recognize that near term customer demand may vary across different markets and asset classes.854  The Agencies understand that reasonably expected near term customer demand may vary based on the liquidity, maturity, and depth of the market for the relevant type of financial instrument(s) in which the trading desk acts as market maker.855  As a result, the final rule recognizes that these factors impact the analysis of reasonably expected near term demands of clients, customers, or counterparties and the amount, types, and risks of market-maker inventory needed to meet such demand.856  In particular, customer demand is likely to be more frequent in more liquid markets than in less liquid or illiquid markets.  As a result, market makers in more liquid cash-based markets, such as liquid equity securities, should generally have higher rates of inventory turnover and less aged inventory than market makers in less liquid or illiquid markets.857  Market makers in less liquid cash-based markets are more likely to hold a particular position for a longer period of time due to intermittent customer demand.  In the derivatives markets, market makers carry open positions and manage various risk factors, such as exposure to different points on a yield curve.  These exposures are analogous to inventory in the cash-based markets.  Further, it may be more difficult to reasonably predict near term customer demand in less mature markets due to, among other things, a lack of historical experience with client, customer, or counterparty demands for the relevant product.  Under these circumstances, the Agencies encourage banking entities to consider their experience with similar products or other relevant factors.858     	
    iii. Demonstrable analysis of certain factors
In the proposal, the Agencies stated that permitted market making includes 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.859  A number of commenters expressed concern about this proposed interpretation’s impact on market makers’ inventory management activity and represented that it was inconsistent with the statute’s near term demand standard, which permits market-making activity that is “designed” not to exceed the “reasonably expected” near term demands of customers.860  In response to comments, the Agencies are permitting a trading desk to take positions in reasonable expectation of customer demand in the near term based on a demonstrable analysis that 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 customers.
The proposal also stated 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).  Several commenters stated that it was unclear how such determinations should be made and expressed concern that near term customer demand cannot always be accurately predicted,861 particularly in markets where trades occur infrequently and customer demand is hard to predict862 or when a banking entity is entering a new market.863  To address these comments, the Agencies are providing additional information about how a banking entity can comply with the statute’s near term customer demand requirement, including a new requirement that a banking entity conduct a demonstrable assessment of reasonably expected near term customer demand and several examples of factors that may be relevant for conducting such an assessment.  The Agencies believe it is important to require such demonstrable analysis to allow determinations of reasonably expected near term demand and associated inventory levels to be monitored and tested to ensure compliance with the statute and the final rule.
The final rule provides that, to help determine the appropriate amount, types, and risks of the financial instruments in the trading desk’s market-maker inventory and to ensure that such inventory is designed not to exceed, on an ongoing basis, the reasonably expected near term demands of client, customers, or counterparties, a banking entity must conduct 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 financial instruments in which the trading desk makes a market, including through block trades.  This analysis should not be static or fixed solely on current market or other factors.  Instead, an appropriately conducted analysis under this provision will be both backward- and forward-looking by taking into account relevant historical trends in customer demand864 and any events that are reasonably expected to occur in the near term that would likely impact demand.865  Depending on the facts and circumstances, it may be proper for a banking entity to weigh these factors differently when conducting an analysis under this provision.  For example, historical trends in customer demand may be less relevant when a trading desk is experiencing or expects to experience a change in the pattern of customer needs (e.g., requests for block positioning), adjustments to its business model (e.g., efforts to expand or contract its market shares), or changes in market conditions.866  On the other hand, absent these types of current or anticipated events, the amount, types, and risks of the financial instruments in the trading desk’s market-maker inventory should be relatively consistent with such trading desk’s historical profile of market-maker inventory.867  
Moreover, the demonstrable analysis required under § __.4(b)(2)(ii)(B) should account for, among other things, how the market factors discussed in § __.4(b)(2)(ii)(A) impact the amount, types, and risks of market-maker inventory the trading desk may need to facilitate reasonably expected near term demands of clients, customers, or counterparties.868  Other potential factors that could be used to assess reasonably expected near term customer demand and the appropriate amount, types, and risks of financial instruments in the trading desk’s market-maker inventory include, among others: (i) recent trading volumes and customer trends; (ii) trading patterns of specific customers or other observable customer demand patterns; (iii) analysis of the banking entity’s business plan and ability to win new customer business; (iv) evaluation of expected demand under current market conditions compared to prior similar periods; (v) schedule of maturities in customers’ existing portfolios; and (vi) expected market events, such as an index rebalancing, and announcements.  The Agencies believe that some banking entities already analyze these and other relevant factors as part of their overall risk management processes.869 
With respect to the creation and distribution of complex structured products, a trading desk may be able to use the market-making exemption to acquire some or all of the risk exposures associated with the product if the trading desk has evidence of customer demand for each of the significant risks associated with the product.870  To have evidence of customer demand under these circumstances, there must be prior express interest from customers in the specific risk exposures of the product.  Without such express interest, a trading desk would not have sufficient information to support the required demonstrable analysis (e.g., information about historical customer demand or other relevant factors).871  The Agencies are concerned that, absent express interest in each significant risk associated with the product, a trading desk could evade the market-making exemption by structuring a deal with certain risk exposures, or amounts of risk exposures, for which there is no customer demand and that would be retained in the trading desk’s inventory, potentially for speculative purposes.  Thus, a trading desk would not be engaged in permitted market making-related activity if, for example, it structured a product solely to acquire a desired exposure and not to respond to customer demand.872  When a trading desk acquires risk exposures in these circumstances, the trading desk would be expected to enter into appropriate hedging transactions or otherwise mitigate the risks of these exposures, consistent with its hedging policies and procedures and risk limits.
With regard to a trading desk that conducts its market-making activities on an exchange or other similar anonymous trading facility, the Agencies continue to believe that market-making 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 non-directional or market-neutral trading strategy or by regularly responding to requests for quotes in markets where resting orders are not generally provided.  This ensures that the trading desk has a pattern of providing, rather than taking, liquidity.  However, this does not mean that a trading desk acting as a market maker on an exchange or other similar anonymous trading facility is only permitted to use these types of orders in connection with its market making-related activities.  The Agencies recognize that it may be appropriate for a trading desk to enter market or marketable limit orders on an exchange or other similar anonymous trading facility, or to request quotes from other market participants, in connection with its market making-related activities for a variety of purposes including, among others, inventory management, addressing order imbalances on an exchange, and hedging.873  In response to comments, the Agencies are not requiring a banking entity to be registered as a market maker on an exchange or other similar anonymous trading facility, if the exchange or other similar anonymous trading facility registers market makers, for purposes of the final rule.874  The Agencies recognize, as noted by commenters, that 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 and that requiring registration with each exchange or other trading facility may unnecessarily restrict or impose burdens on exchange market-making activities.875
A banking entity is not required to conduct the demonstrable analysis under § __.4(b)(2)(B) of the final rule on an instrument-by-instrument basis.  The Agencies recognize that, in certain cases, customer demand may be for a particular type of exposure, and a customer may be willing to trade any one of a number of instruments that would provide the demanded exposure.  Thus, an assessment of the amount, types, and risks of financial instruments that the trading desk may hold in market-maker inventory and that would be designed not to exceed, on an ongoing basis, the reasonably expected near term demands of clients, customers, or counterparties does not need to be made for each financial instrument in which the trading desk acts as market maker.  Instead, the amount and types of financial instruments in the trading desk’s market-maker inventory should be consistent with the types of financial instruments in which the desk makes a market and the amount and types of such instruments that the desk’s customers are reasonably expected to be interested in trading.  
In response to commenters’ concern that banking entities may be subject to regulatory sanctions if reasonably expected customer demand does not materialize,876 the Agencies recognize that predicting the reasonably expected near term demands of clients, customers, or counterparties is inherently subject to changes based on market and other factors that are difficult to predict with certainty.  Thus, there may at times be differences between predicted demand and actual demand from clients, customers, or counterparties.  However, assessments of expected near term demand may not be reasonable if, in the aggregate and over longer periods of time, a trading desk exhibits a repeated pattern or practice of significant variation in the amount, types, and risks of financial instruments in its market-maker inventory in excess of what is needed to facilitate near term customer demand.   
    iv. Relationship to required limits
As discussed further below, a banking entity must establish limits for each trading desk on the amount, types, and risks of its market-maker inventory, level of exposures to relevant risk factors arising from its financial exposure, and period of time a financial instrument may be held by a trading desk.  These limits must be reasonably designed to ensure compliance with the market-making exemption, including the near term customer demand requirement, and must take into account the nature and amount of the trading desk’s market making-related activities.  Thus, the limits should account for and generally be consistent with the historical near term demands of the desk’s clients, customers, or counterparties and the amount, types, and risks of financial instruments that the trading desk has historically held in market-maker inventory to meet such demands.  In addition to the limits that a trading desk selects in managing its positions to ensure compliance with the market-making exemption set out in § __.4(b), the Agencies are requiring, for banking entities that must report metrics in Appendix A, such limits include, at a minimum, “Risk Factor Sensitivities” and “Value-at-Risk and Stress Value-at-Risk” metrics as limits, except to the extent any of the “Risk Factor Sensitivities” or “Value-at-Risk and Stress Value-at-Risk” metrics are demonstrably ineffective  for measuring and monitoring the risks of a trading desk based on the types of positions traded by, and risk exposures of, that desk.877  The Agencies believe that these metrics can be useful for measuring and managing many types of positions and trading activities and therefore can be useful in establishing a minimum set of metrics for which limits should be applied.878 
As this requirement applies on an ongoing basis, a trade in excess of one or more limits set for a trading desk should not be permitted simply because it responds to customer demand.  Rather, a banking entity’s compliance program must 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 requirements of this near term demand requirement and with the prudent management of risk by the banking entity, and independent review of such demonstrable analysis and approval.879  The Agencies expect that a trading desk’s escalation procedures will generally explain the circumstances under which a trading desk’s limits can be increased, either temporarily or permanently, and that such increases must be consistent with reasonably expected near term demands of the desk’s clients, customers, or counterparties and the amount and type of risks to which the trading desk is authorized to be exposed.   
                            3. Compliance program requirement	
                                a. Proposed compliance program requirement
To ensure that a banking entity relying on the market-making exemption had an appropriate framework in place to support its compliance with the exemption, § __.4(b)(2)(i) of the proposed rule required a banking entity to establish an internal compliance program, as required by subpart D of the proposal, designed to ensure compliance with the requirements of the market-making exemption.880
                                b. Comments on the proposed compliance program requirement
	A few commenters supported the proposed requirement that a banking entity establish a compliance program under § __.20 of the proposed rule as effective.881  For example, one commenter stated that the requirement “keeps a strong focus on the bank’s own workings and allows banks to self-monitor.”882  One commenter indicated that a comprehensive compliance program is a “cornerstone of effective corporate governance,” but cautioned against placing “undue reliance” on compliance programs.883  As discussed further below in Parts IV.C.1. and IV.C.3., many commenters expressed concern about the potential burdens of the proposed rule’s compliance program requirement, as well as the proposed requirement regarding quantitative measurements.  According to one commenter, the compliance burdens associated with these requirements may dissuade a banking entity from attempting to comply with the market-making exemption.884
                                c. Final compliance program requirement
	Similar to the proposed exemption, the market-making exemption adopted in the final rule requires that a banking entity establish and implement, maintain, and enforce an internal compliance program required by subpart D that is reasonably designed to ensure the banking entity’s compliance with the requirements of the market-making exemption, including reasonably designed written policies and procedures, internal controls, analysis, and independent testing.885  This provision further requires that the compliance program include particular written policies and procedures, internal controls, analysis, and independent testing identifying and addressing:
    • The financial instruments each trading desk stands ready to purchase and sell as a market maker; 
    • The actions the trading desk will take to demonstrably reduce or otherwise significantly mitigate promptly the risks of its financial exposure consistent with the required 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; 
    • Limits for each trading desk, based on the nature and amount of the trading desk’s market making-related activities, that address the factors prescribed by the near term customer demand requirement of the final rule, 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;
        ◦ Level of exposures to relevant risk factors arising from its financial exposure; and 
        ◦ Period of time a financial instrument may be held;
    • Internal controls and ongoing monitoring and analysis of each trading desk’s compliance with its required limits; and 
    • Authorization procedures, including escalation procedures that 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 § __.4(b)(2)(ii) of the final rule, 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.886
	The compliance program requirement in the proposed market-making exemption did not include specific references to all the compliance program elements now listed in the final rule.  Instead, these elements were generally included in the compliance requirements of Appendix C of the proposed rule.  The Agencies are moving certain of these requirements into the market-making exemption to ensure that critical components are made part of the compliance program for market making-related activities.  Further, placing these requirements within the market-making exemption emphasizes the important role they play in overall compliance with the exemption.887  Banking entities should note that these compliance procedures must be established, implemented, maintained, and enforced for each trading desk engaged in market making-related activities under the final rule.  Each of the requirements in paragraphs (b)(2)(iii)(A) through (E) must be appropriately tailored to the individual trading activities and strategies of each trading desk on an ongoing basis.  
As a threshold issue, the compliance program must identify the products, instruments, and exposures the trading desk may trade as market maker or for risk management purposes.888  Identifying the relevant instruments in which a trading desk is permitted to trade will facilitate monitoring and oversight of compliance with the exemption by preventing an individual trader on a market-making desk from establishing positions in instruments that are unrelated to the desk’s market-making function.  Further, this identification of instruments helps form the basis for the specific types of inventory and risk limits that the banking entity must establish and is relevant to considerations throughout the exemption regarding the liquidity, depth, and maturity of the market for the relevant type of financial instrument.  The Agencies note that a banking entity should be able to demonstrate the relationship between the instruments in which a trading desk may act as market maker and the instruments the desk may use to manage the risk of its market making-related activities and inventory and why the instruments the desk may use to manage its risk appropriately and effectively mitigate the risk of its market making-related activities without generating an entirely new set of risks that outweigh the risks that are being hedged.  
The final rule provides that a banking entity must establish an appropriate risk management framework for each of its trading desks that rely on the market-making exemption.889  This includes not only the techniques and strategies that a trading desk may use to manage its risk exposures, but also the actions the trading desk will take to demonstrably reduce or otherwise significantly mitigate promptly the risks of its financial exposures consistent with its required limits, which are discussed in more detail below.  While the Agencies do not expect a trading desk to hedge all of the risks that arise from its market making-related activities, the Agencies do expect each trading desk to take appropriate steps consistent with market-making activities to contain and limit risk exposures (such as by unwinding unneeded positions) and to follow reasonable procedures to monitor the trading desk’s risk exposures (i.e., its financial exposure) and hedge risks of its financial exposure to remain within its relevant risk limits.890   
As discussed in Part IV.A.3.c.4.c., managing the risks associated with maintaining a market-maker inventory that is appropriate to meet the reasonably expected near-term demands of customers is an important part of market making.891  The Agencies understand that, in the context of market-making activities, inventory management includes adjustment of the amount and types of market-maker inventory to meet the reasonably expected near term demands of customers.892  Adjustments of the size and types of a financial exposure are also made to reduce or mitigate the risks associated with financial instruments held as part of a trading desk’s market-maker inventory.  A common strategy in market making is to establish market-maker inventory in anticipation of reasonably expected customer needs and then to reduce that market-maker inventory over time as customer demand materializes.893  If customer demand does not materialize, the market maker addresses the risks associated with its market-maker inventory by adjusting the amount or types of financial instruments in its inventory as well as taking steps otherwise to mitigate the risk associated with its inventory.
The Agencies recognize that, to provide effective intermediation services, a trading desk engaged in permitted market making-related activities retains a certain amount of risk arising from the positions it holds in inventory and may hedge certain aspects of that risk.  The requirements in the final rule establish controls around a trading desk’s risk management activities, yet still recognize that a trading desk engaged in market making-related activities may retain a certain amount of risk in meeting the reasonably expected near term demands of clients, customers, or counterparties.  As the Agencies noted in the proposal, where the purpose of a transaction is to hedge a market making-related position, it would appear to be market making-related activity of the type described in section 13(d)(1)(B) of the BHC Act.894  The Agencies emphasize that the only risk management activities that qualify for the market-making exemption – and that are not subject to the hedging exemption – are risk management activities conducted or directed by the trading desk in connection with its market making-related activities and in conformance with the trading desk’s risk management policies and procedures.895  A trading desk engaged in market making-related activities would be required to comply with the hedging exemption or another available exemption for any risk management or other activity that is not in conformance with the trading desk’s required market-making risk management policies and procedures.
A banking entity’s written policies and procedures, internal controls, analysis, and independent testing identifying and addressing the products, instruments, or exposures and the techniques and strategies that may be used by each trading desk to manage the risks of its market making-related activities and inventory must cover both how the trading desk may establish hedges and how such hedges are removed once the risk they were mitigating is unwound.  With respect to establishing positions that hedge or otherwise mitigate the risk(s) of market making-related positions held by the trading desk, the written policies and procedures may consider the natural hedging and diversification that occurs in an aggregation of long and short positions in financial instruments for which the trading desk is a market maker,896 as it documents its specific risk-mitigating strategies that use instruments for which the desk is a market maker or instruments for which the desk is not a market maker.  Further, the written policies and procedures identifying and addressing permissible hedging techniques and strategies must address the circumstances under which the trading desk may be permitted to engage in anticipatory hedging.  Like the proposed rule’s hedging exemption, a trading desk may establish an anticipatory hedge position before it becomes exposed to a risk that it is highly likely to become exposed to, provided there is a sound risk management rationale for establishing such an anticipatory hedge position.897  For example, a trading desk may hedge against specific positions promised to customers, such as volume-weighted average price (“VWAP”) orders or large block trades, to facilitate the customer trade.898  The amount of time that an anticipatory hedge may precede the establishment of the position to be hedged will depend on market factors, such as the liquidity of the hedging position.   
Written policies and procedures, internal controls, analysis, and independent testing established pursuant to the final rule identifying and addressing permissible hedging techniques and strategies should be designed to prevent a trading desk from over-hedging its market-maker inventory or financial exposure.  Over-hedging would occur if, for example, a trading desk established a position in a financial instrument for the purported purpose of reducing a risk associated with one or more market-making positions when, in fact, that risk had already been mitigated to the full extent possible.  Over-hedging results in a new risk exposure that is unrelated to market-making activities and, thus, is not permitted under the market-making exemption.      
A trading desk’s financial exposure generally would not be considered to be consistent with market making-related activities to the extent the trading desk is engaged in hedging activities that are inconsistent with the management of identifiable risks in its market-maker inventory or maintains significant hedge positions after the underlying risk(s) of the market-maker inventory have been unwound.  A banking entity’s written policies and procedures, internal controls, analysis, and independent testing regarding the trading desk’s permissible hedging techniques and strategies must be designed to prevent a trading desk from engaging in over-hedging or maintaining hedge positions after they are no longer needed.899  Further, the compliance program must provide for the process and personnel responsible for ensuring that the actions taken by the trading desk to mitigate the risks of its market making-related activities are and continue to be effective, which would include monitoring for and addressing any scenarios where a trading desk may be engaged in over-hedging or maintaining unnecessary hedge positions or new significant risks have been introduced by the hedging activity.  
As a result of these limitations, the size and risks of the trading desk’s hedging positions are naturally constrained by the size and risks of its market-maker inventory, which must be designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties, as well as by the risk limits and controls established under the final rule.  This ultimately constrains a trading desk’s overall financial exposure since such position can only contain positions, risks, and exposures related to the market-maker inventory that are designed to meet current or near term customer demand and positions, risks and exposures designed to mitigate the risks in accordance with the limits previously established for the trading desk.    
The written policies and procedures identifying and addressing a trading desk’s hedging techniques and strategies also must describe how and under what timeframe a trading desk must remove hedge positions once the underlying risk exposure is unwound.  Similarly, the compliance program established by the banking entity to specify and control the trading desk’s hedging activities in accordance with the final rule must be designed to prevent a trading desk from purposefully or inadvertently transforming its positions taken to manage the risk of its market-maker inventory under the exemption into what would otherwise be considered prohibited proprietary trading.  
Moreover, the compliance program must provide for the process and personnel responsible for ensuring that the actions taken by the trading desk to mitigate the risks of its market making-related activities and inventory – including the instruments, techniques, and strategies used for risk management purposes – are and continue to be effective.  This includes ensuring that hedges taken in the context of market making-related activities continue to be effective and that positions taken to manage the risks of the trading desk’s market-maker inventory are not purposefully or inadvertently transformed into what would otherwise be considered prohibited proprietary trading.  If a banking entity’s monitoring procedures find that a trading desk’s risk management procedures are not effective, such deficiencies must be promptly escalated and remedied in accordance with the banking entity’s escalation procedures.  A banking entity’s written policies and procedures must set forth the process for determining the circumstances under which a trading desk’s risk management strategies may be modified.  In addition, risk management techniques and strategies developed and used by a trading desk must be independently tested or verified by management separate from the trading desk.  
 To control and limit the amount and types of financial instruments and risks that a trading desk may hold in connection with its market making-related activities, a banking entity must establish, implement, maintain, and enforce reasonably designed written policies and procedures, internal controls, analysis, and independent testing identifying and addressing specific limits on a trading desk’s market-maker inventory, risk management positions, and financial exposure.  In particular, the compliance program must establish limits for each trading desk, based on the nature and amount of its market making-related activities (including the factors prescribed by the near term customer demand requirement), 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 may use 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.900  The limits would be set, as appropriate, and supported by an analysis for specific types of financial instruments, levels of risk, and duration of holdings, which would also be required by the compliance appendix.  This approach will build on existing risk management infrastructure for market-making activities that subject traders to a variety of internal, predefined limits.901  Each of these limits is independent of the others, and a trading desk must maintain its aggregated market-making position within each of these limits, including by taking action to bring the trading desk into compliance with the limits as promptly as possible after the limit is exceeded.902  For example, if changing market conditions cause an increase in one or more risks within the trading desk’s financial exposure and that increased risk causes the desk to exceed one or more of its limits, the trading desk must take prompt action to reduce its risk exposure (either by hedging the risk or unwinding its existing positions) or receive approval of a temporary or permanent increase to its limit through the required escalation procedures.  
The Agencies recognize that trading desks’ limits will differ across asset classes and acknowledge that trading desks engaged in market making-related activities in less liquid asset classes, such as corporate bonds, certain derivatives, and securitized products, may require different inventory, risk exposure, and holding period limits than trading desks engaged in market making-related activities in more liquid financial instruments, such as certain listed equity securities.  Moreover, the types of risk factors for which limits are established should not be limited solely to market risk factors.  Instead, such limits should also account for all risk factors that arise from the types of financial instruments in which the trading desk is permitted to trade.  In addition, these limits should be sufficiently granular and focused on the particular types of financial instruments in which the desk may trade.  For example, a trading desk that makes a market in derivatives would have exposures to counterparty risk, among others, and would need to have appropriate limits on such risk.  Other types of limits that may be relevant for a trading desk include, among others, position limits, sector limits, and geographic limits.  
A banking entity must have a reasonable basis for the limits it establishes for a trading desk and must have a robust procedure for analyzing, establishing, and monitoring limits, as well as appropriate escalation procedures.903  Among other things, the banking entity’s compliance program must provide for: (i) written policies and procedures and internal controls establishing and monitoring specific limits for each trading desk; and (ii) analysis regarding how and why these limits are determined to be appropriate and consistent with the nature and amount of the desk’s market making-related activities, including considerations related to the near term customer demand requirement.  In making these determinations, a banking entity should take into account and be consistent with the type(s) of financial instruments the desk is permitted to trade, the desk’s trading and risk management activities and strategies, the history and experience of the desk, and the historical profile of the desk’s near term customer demand and market and other factors that may impact the reasonably expected near term demands of customers.  
The limits established by a banking entity should generally reflect the amount and types of inventory and risk that a trading desk holds to meet the reasonably expected near term demands of clients, customers, or counterparties.  As discussed above, while the trading desk’s market-maker inventory is directly limited by the reasonably expected near term demands of customers, the positions managed by the trading desk outside of its market-maker inventory are similarly constrained by the near term demand requirement because they must be designed to manage the risks of the market-maker inventory in accordance with the desk’s risk management procedures.  As a result, the trading desk’s risk management positions and aggregate financial exposure are also limited by the current and reasonably expected near term demands of customers.  A trading desk’s market-maker inventory, risk management positions, or financial exposure would not, however, be permissible under the market-making exemption merely because the market-maker inventory, risk management positions, or financial exposure happens to be within the desk’s prescribed limits.904         
In addition, 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 and patterns regarding the portions of the trading desk’s limits that are accounted for by the trading desk’s activity.905  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 or modifications to the trading desk’s strategy).906  This process must cover potential scenarios when a trading desk’s limits should be raised, as well as potential scenarios when a trading desk’s limits should be lowered.  For example, if a trading desk experiences reduced customer demand over a period of time, that trading desk’s limits should be decreased to address the factors prescribed by the near term demand requirement.
A banking entity’s compliance program 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 of any increase to one or more of a trading desk’s limits.907  Thus, in order to increase a limit of a trading desk – on either a temporary or permanent basis – 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, including the factors identified in § __.4(b)(2)(ii) of the final rule, which must be independently reviewed.  A banking entity also must maintain documentation and records with respect to these elements, consistent with the requirement of § __.20(b)(6).  	
As already discussed, commenters have represented that the compliance costs associated with the proposed rule, including the compliance program and metrics requirements, may be significant and “may dissuade a banking entity from attempting to comply with the market making-related activities exemption.”908  The Agencies believe that a robust compliance program is necessary to ensure adherence to the rule and to prevent evasion, although, as discussed in Part IV.C.3., the Agencies are adopting a more tailored set of quantitative measurements to better focus on those that are most germane to evaluating market making-related activity.  The Agencies acknowledge that the compliance program requirements for the market-making exemption, including reasonably designed written policies and procedures, internal controls, analysis, and independent testing, represent a new regulatory requirement for banking entities and the Agencies have thus been mindful that it may impose significant costs and may cause a banking entity to reconsider whether to conduct market making-related activities.  Despite the potential costs of the compliance program, the Agencies believe they are warranted to ensure that the goals of the rule and statute will be met, such as promoting the safety and soundness of banking entities and the financial stability of the United States.
                            4. Market making-related hedging
                                a. Proposed treatment of market making-related hedging
	In the proposal, certain hedging transactions related to market making were considered to be made in connection with a banking entity’s market making-related activity for purposes of the market-making exemption.  The Agencies explained that where the purpose of a transaction is to hedge a market making-related position, it would appear to be market making-related activity of the type described in section 13(d)(1)(B) of the BHC Act.909  To qualify for the market-making exemption, a hedging transaction would have been required to meet certain requirements under § __.4(b)(3) of the proposed rule.  This provision required that the purchase or sale of a financial instrument: (i) be conducted to reduce the specific risks to the banking entity in connection with and related to individual or aggregated positions, contracts, or other holdings acquired pursuant to the market-making exemption; and (ii) meet the criteria specified in § __.5(b) of the proposed hedging exemption and, where applicable, § __.5(c) of the proposal.910  In the proposal, the Agencies noted 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. The Agencies stated that this type of hedging transaction would meet the terms of the market-making exemption if the hedging transaction met the requirements of § __.4(b)(3) of the proposed rule.911  
                                b. Comments on the proposed treatment of market making-related hedging
	Several commenters recommended that the proposed market-making exemption be modified to establish a more permissive standard for market maker hedging.912  A few of these commenters stated that, rather than applying the standards of the risk-mitigating hedging exemption to market maker hedging, a market maker’s hedge position should be permitted as long as it is designed to mitigate the risk associated with positions acquired through permitted market making-related activities.913  Other commenters emphasized the need for flexibility to permit a market maker to choose the most effective hedge.914  In general, these commenters expressed concern that limitations on hedging market making-related positions may cause a reduction in liquidity, wider spreads, or increased risk and trading costs for market makers.915  For example, one commenter stated that “[t]he ability of market makers to freely offset or hedge positions is what, in most cases, makes them willing to buy and sell [financial instruments] to and from customers, clients or counterparties,” so “[a]ny impediment to hedging market making-related positions will decrease the willingness of banking entities to make markets and, accordingly, reduce liquidity in the marketplace.”916
	In addition, some commenters expressed concern that certain requirements in the proposed hedging exemption may result in a reduction in market-making activities under certain circumstances.917  For example, one commenter expressed concern that the proposed hedging exemption would require a banking entity to identify and tag hedging transactions when hedges in a particular asset class take place alongside a trading desk’s customer flow trading and inventory management in that same asset class.918  Further, a few commenters represented that the proposed reasonable correlation requirement in the hedging exemption could impact market making by discouraging market makers from entering into customer transactions that do not have a direct hedge919 or making it more difficult for market makers to cost-effectively hedge the fixed income securities they hold in inventory, including hedging such inventory positions on a portfolio basis.920
	One commenter, however, stated that the proposed approach is effective.921  Another commenter indicated that it is confusing to include hedging within the market-making exemption and suggested that a market maker be required to rely on the hedging exemption under § __.5 of the proposed rule for its hedging activity.922  
	As noted above in the discussion of comments on the proposed source of revenue requirement, a number of commenters expressed concern that the proposed rule assumed that there are effective, or perfect, hedges for all market making-related positions.923  Another commenter stated that market makers should be required to hedge whenever an inventory imbalance arises, and the absence of a hedge in such circumstances may evidence prohibited proprietary trading.924
                                c. Treatment of market making-related hedging in the final rule
Unlike the proposed rule, the final rule does not require that market making-related hedging activities separately comply with the requirements found in the risk-mitigating hedging exemption if conducted or directed by the same trading desk conducting the market-making activity.  Instead, the Agencies are including requirements for market making-related hedging activities within the market-making exemption in response to comments.925  As discussed above, a trading desk’s compliance program must include written policies and procedures, internal controls, independent testing and analysis identifying and addressing the products, instruments, exposures, techniques, and strategies a trading desk may use to manage the risks of its market making-related activities, as well as the actions the trading desk will take to demonstrably reduce or otherwise significant mitigate the risks of its financial exposure consistent with its required limits.926  The Agencies believe this approach addresses commenters’ concerns that limitations on hedging market making-related positions may cause a reduction in liquidity, wider spreads, or increased risk and trading costs for market makers because it allows banking entities to determine how best to manage the risks of trading desks’ market making-related activities through reasonable policies and procedures, internal controls, independent testing, and analysis, rather than requiring compliance with the specific requirements of the hedging exemption.927  Further, this approach addresses commenters’ concerns about the impact of certain requirements of the hedging exemption on market making-related activities.928
The Agencies believe it is consistent with the statute’s reference to “market making-related” activities to permit market making-related hedging activities under this exemption.  In addition, the Agencies believe it is appropriate to require a trading desk to appropriately manage its risks, consistent with its risk management procedures and limits, because management of risk is a key factor that distinguishes permitted market making-related activity from impermissible proprietary trading.  As noted in the proposal, while “a market maker attempts to eliminate some [of the risks arising from] its retained principal positions and risks by hedging or otherwise managing those risks [ ], a proprietary trader seeks to capitalize on those risks, and generally only hedges or manages a portion of those risks when doing so would improve the potential profitability of the risk it retains.”929
The Agencies recognize that some banking entities may manage the risks associated with market making at a different level than the individual trading desk.930  While this risk management activity is not permitted under the market-making exemption, it may be permitted under the hedging exemption, provided the requirements of that exemption are met.  Thus, the Agencies believe banking entities will continue to have options available that allow them to efficiently hedge the risks arising from their market-making operations.  Nevertheless, the Agencies understand that this rule will result in additional documentation or other potential burdens for market making-related hedging activity that is not conducted by the trading desk responsible for the market-making positions being hedged.931  As discussed in Part IV.A.4.d.4., hedging conducted by a different organizational unit than the trading desk that is responsible for the underlying positions presents an increased risk of evasion, so the Agencies believe it is appropriate for such hedging activity to be required to comply with the hedging exemption, including the associated documentation requirement.
                            5. Compensation requirement
                                a. Proposed compensation requirement
Section __.4(b)(2)(vii) of the proposed market-making exemption would have required that the compensation arrangements of persons performing market making-related activities at the banking entity be designed not to reward proprietary risk-taking.932  In the proposal, the Agencies noted 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 financial instrument position held in inventory, rather than success in providing effective and timely intermediation and liquidity services to customers, would be inconsistent with the proposed market-making exemption. 
The Agencies stated that under the proposed rule, a banking entity relying on the market-making exemption should provide compensation incentives that primarily reward customer revenues and effective customer service, not proprietary risk-taking.  However, the Agencies noted that a banking entity relying on the proposed market-making exemption would be able to 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 principal risk retained.933    
                                b. Comments regarding the proposed compensation requirement
	Several commenters recommended certain revisions to the proposed compensation requirement.934  Two commenters stated that the proposed requirement is effective,935 while one commenter stated that it should be removed from the rule.936  Moreover, in addressing this proposed requirement, commenters provided views on: identifiable characteristics of compensation arrangements that incentivize prohibited proprietary trading,937 methods of monitoring compliance with this requirement,938 and potential negative incentives or outcomes this requirement could cause.939
	With respect to suggested modifications to this requirement, a few commenters suggested that a market maker’s compensation should be subject to additional limitations.940  For example, two commenters stated that compensation should be restricted to particular sources, such as fees, commissions, and spreads.941  One commenter suggested that compensation should not be symmetrical between gains and losses and, further, that trading gains reflecting an unusually high variance in position values should either not be reflected in compensation and bonuses or should be less reflected than other gains and losses.942  Another commenter recommended that the Agencies remove “designed” from the rule text and provide greater clarity about how a banking entity’s compensation regime must be structured.943  Moreover, a number of commenters stated that compensation should be vested for a period of time, such as until the trader’s market making positions have been fully unwound and are no longer in the banking entity’s inventory.944  As one commenter explained, such a requirement would discourage traders from carrying inventory and encourage them to get out of positions as soon as possible.945  Some commenters also recommended that compensation be risk adjusted.946 
	A few commenters indicated that the proposed approach may be too restrictive.947  Two of these commenters stated that the compensation requirement should instead be set forth as guidance in Appendix B.948  In addition, two commenters requested that the Agencies clarify that compensation arrangements must be designed not to reward prohibited proprietary risk-taking.  These commenters were concerned the proposed approach may restrict a banking entity’s ability to provide compensation for permitted activities, which also involve proprietary trading.949   	 
	Two commenters discussed identifiable characteristics of compensation arrangements that clearly incentivize prohibited proprietary trading.950  For example, one commenter stated that rewarding pure profit and loss, without consideration for the risk that was assumed to capture it, is an identifiable characteristic of an arrangement that incentivizes proprietary risk-taking.951  For purposes of monitoring and ensuring compliance with this requirement, one commenter noted that existing Board regulations for systemically important banking entities require comprehensive firm-wide policies that determine compensation.  This commenter stated that those regulations, along with appropriately calibrated metrics, should ensure that compensation arrangements are not designed to reward prohibited proprietary risk-taking.952  For similar purposes, another commenter suggested that compensation incentives should be based on a metric that meaningfully accounts for the risk underlying profitability.953
	Certain commenters expressed concern that the proposed compensation requirement could incentivize market makers to act in a way that would not be beneficial to customers or market liquidity.954  For example, two commenters expressed concern that the requirement could cause market makers to widen their spreads or charge higher fees because their personal compensation depends on these factors.955  One commenter stated that the proposed requirement could dampen traders’ incentives and discretion and may make market makers less likely to accept trades involving significant increases in risk or profit.956  Another commenter expressed the view that profitability-based compensation arrangements encourage traders to exercise due care because such arrangements create incentives to avoid losses.957  Finally, one commenter stated that compliance with the proposed requirement may be difficult or impossible if the Agencies do not take into account the incentive-based compensation rulemaking.958
                                c. Final compensation requirement
	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.959  The language of the final compensation requirement has been modified in response to comments expressing concern about the proposed language regarding “proprietary risk-taking.”960  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.961  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.  
                            6. Registration requirement
                                a. Proposed registration requirement
	 Under § __.4(b)(2)(iv) of the proposed rule, a banking entity relying on the market-making exemption with respect to trading in securities or certain derivatives would be required to be appropriately registered as a securities dealer, swap dealer, or security-based swap dealer, or exempt from registration or excluded from regulation as such type of dealer, under applicable securities or commodities laws.  Further, if the banking entity was engaged in the business of a securities dealer, swap dealer, or security-based swap dealer outside the United States in a manner for which no U.S. registration is required, the banking entity would be required to be subject to substantive regulation of its dealing business in the jurisdiction in which the business is located.962
                                b. Comments on the proposed registration requirement
	A few commenters stated that the proposed dealer registration requirement is effective.963  However, a number of commenters opposed the proposed dealer registration requirement in whole or in part.964  Commenters’ primary concern with the requirement appeared to be its application to market making-related activities outside of the United States for which no U.S. registration is required.965  For example, several commenters stated that many non-U.S. markets do not provide substantive regulation of dealers for all asset classes.966  In addition, two commenters stated that booking entities may be able to rely on intra-group exemptions under local law rather than carrying dealer registrations, or a banking entity may execute customer trades through an international dealer but book the position in a non-dealer entity for capital adequacy and risk management purposes.967  Several of these commenters requested, at a minimum, that the dealer registration requirement not apply to dealers in non-U.S. jurisdictions.968
	In addition, with respect to the provisions that would generally require a banking entity to be a form of SEC- or CFTC-registered dealer for market-making activities in securities or derivatives in the United States, a few commenters stated that these provisions should be removed from the rule.969  These commenters represented that removing these provisions would be appropriate for several reasons.  For example, one commenter stated that dealer registration does not help distinguish between market making and speculative trading.970  Another commenter indicated that effective market making often requires a banking entity to trade on several exchange and platforms in a variety of markets, including through legal entities other than SEC- or CFTC-registered dealer entities.971  One commenter expressed general concern that the proposed requirement may result in the market-making exemption being unavailable for market making in exchange-traded futures and options because those markets do not have a corollary to dealer registration requirements in securities, swaps, and security-based swaps markets.972
	Some commenters expressed particular concern about the provisions that would generally require registration as a swap dealer or a security-based swap dealer.973  For example, one commenter expressed concern that these provisions may require banking regulators to redundantly enforce CFTC and SEC registration requirements.  Moreover, according to this commenter, the proposed definitions of “swap dealer” and “security-based swap dealer” do not focus on the market making core of the swap dealing business.974  Another commenter stated that incorporating the proposed definitions of “swap dealer” and “security-based swap dealer” is contrary to the Administrative Procedure Act.975   
                                c. Final registration requirement
	The final requirement of the market-making exemption provides that the banking entity must be licensed or registered to engage in market making-related activity in accordance with applicable law.976  The Agencies have considered comments regarding the dealer registration requirement in the proposed rule.977  In response to comments, the Agencies have narrowed the scope of the proposed requirement’s application to banking entities engaged in market making-related activity in foreign jurisdictions.978  Rather than requiring these banking entities to be subject to substantive regulation of their dealing business in the relevant foreign jurisdiction, the final rule only require a banking entity to be a registered dealer in a foreign jurisdiction to the extent required by applicable foreign law.  The Agencies have also simplified the language of the proposed requirement, although the Agencies have not modified the scope of the requirement with respect to U.S. dealer registration requirements.
	This provision is not intended to expand the scope of licensing or registration requirements under relevant U.S. or foreign law that are applicable to a banking entity engaged in market-making activities.  Instead, this provision recognizes that compliance with applicable law is an essential indicator that a banking entity is engaged in market-making activities.979  For example, a U.S. banking entity would be expected to be an SEC-registered dealer to rely on the market-making exemption for trading in 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.980  Similarly, a U.S. banking entity is expected to be a CFTC-registered swap dealer or SEC-registered security-based swap dealer to rely on the market-making exemption for trading in swaps or security-based swaps, respectively,981 unless the banking entity is exempt from registration or excluded from regulation as a swap dealer or security-based swap dealer.982  In response to comments on whether this provision should generally require registration as a swap dealer or security-based swap dealer to make a market in swaps or security-based swaps,983 the Agencies continue to believe that this requirement is appropriate.  In general, a person that is engaged in making a market in swaps or security-based swaps or other activity causing oneself to be commonly known in the trade as a market maker in swaps or security-based swaps is required to be a registered swap dealer or registered security-based swap dealer, unless exempt from registration or excluded from regulation as such.984  As noted above, compliance with applicable law is an essential indicator that a banking entity is engaged in market-making activities.  
As noted above, the Agencies have determined that, rather than require a banking entity engaged in the business of a securities dealer, swap dealer, or security-based swap dealer outside the United States to be subject to substantive regulation of its dealing business in the foreign 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 requirements under applicable foreign law (provided no U.S. registration or licensing requirements apply to the banking entity’s activities).  As a result, this requirement will not impact a banking entity’s ability to engage in permitted market making-related activities in a foreign jurisdiction that does not provide for substantive regulation of dealers.985      
                            7. Source of revenue analysis
                                a. Proposed source of revenue requirement
	To qualify for the market-making exemption, the proposed rule required that the market making-related activities of the trading desk or other organizational unit be designed to generate revenues primarily from fees, commissions, bid/ask spreads or other income not attributable to appreciation in the value of financial instrument positions it holds in trading accounts or the hedging of such positions.986  This proposed requirement was intended to ensure that activities conducted in reliance on the market-making exemption demonstrate patterns of revenue generation and profitability consistent with, and related to, the intermediation and liquidity services a market maker provides to its customers, rather than changes in the market value of the positions or risks held in inventory.987
                                b. Comments regarding the proposed source of revenue requirement
	As discussed in more detail below, many commenters expressed concern about the proposed source of revenue requirement.  These commenters raised a number of concerns including, among others, the proposed requirement’s potential impact on a market maker’s inventory or on costs to customers, the difficulty of differentiating revenues from spreads and revenues from price appreciation in certain markets, and the need for market makers to be compensated for providing intermediation services.988  Several of these commenters requested that the proposed source of revenue requirement be removed from the rule or modified in certain ways.  Some commenters, however, expressed support for the proposed requirement or requested that the Agencies place greater restrictions on a banking entity’s permissible sources of revenue under the market-making exemption.989 
    i. Potential restrictions on inventory, increased costs for customers, and other changes to market-making services
	Many commenters stated that the proposed source of revenue requirement may limit a market maker’s ability to hold sufficient inventory to facilitate customer demand.990  Several of these commenters expressed particular concern about applying this requirement to less liquid markets or to facilitating large customer positions, where a market maker is more likely to hold inventory for a longer period of time and has increased risk of potential price appreciation (or depreciation).991  Further, another commenter questioned how the proposed requirement would apply when unforeseen market pressure or disappearance of customer demand results in a market maker holding a particular position in inventory for longer than expected.992  In response to this proposed requirement, a few commenters stated that it is important for market makers to be able to hold a certain amount of inventory to: provide liquidity (particularly in the face of order imbalances and market volatility),993 facilitate large trades, and hedge positions acquired in the course of market making.994
	Several commenters expressed concern that the proposed source of revenue requirement may incentivize a market maker to widen its quoted spreads or otherwise impose higher fees to the detriment of its customers.995  For example, some commenters stated that the proposed requirement could result in a market maker having to sell a position in its inventory within an artificially prescribed period of time and, as a result, the market maker would pay less to initially acquire the position from a customer.996  Other commenters represented that the proposed source of revenue requirement would compel market makers to hedge their exposure to price movements, which would likely increase the cost of intermediation.997  
	Some commenters stated that the proposed source of revenue requirement may make a banking entity less willing to make markets in instruments that it may not be able to resell immediately or in the short term.998  One commenter indicated that this concern may be heightened in times of market stress.999  Further, a few commenters expressed the view that the proposed requirement would cause banking entities to exit the market-making business due to restrictions on their ability to make a profit from market-making activities.1000  Moreover, in one commenter’s opinion, the proposed requirement would effectively compel market makers to trade on an agency basis.1001
    ii. Certain price appreciation-related profits are an inevitable or important component of market making

	A number of commenters indicated that market makers will inevitably make some profit from price appreciation of certain inventory positions because changes in market values cannot be precisely predicted or hedged.1002  In particular, several commenters emphasized that matched or perfect hedges are generally unavailable for most types of positions.1003  According to one commenter, a provision that effectively requires a market-making business to hedge all of its principal positions would discourage essential market-making activity.  The commenter explained that effective hedges may be unavailable in less liquid markets and hedging can be costly, especially in relation to the relative risk of a trade and hedge effectiveness.1004  A few commenters further indicated that making some profit from price appreciation is a natural part of market making or is necessary to compensate a market maker for its willingness to take a position, and its associated risk (e.g., the risk of market changes or decreased value), from a customer.1005
    iii. Concerns regarding the workability of the proposed standard in certain markets or asset classes
	Some commenters represented that it would be difficult or burdensome to identify revenue attributable to the bid-ask spread versus revenue arising from price appreciation, either as a general matter or for specific markets.1006  For example, one commenter expressed the opinion that the difference between the bid-ask spread and price appreciation is “metaphysical” in some sense,1007 while another stated that it is almost impossible to objectively identify a bid-ask spread or to capture profit and loss solely from a bid-ask spread in most markets.1008  Other commenters represented that it is particularly difficult to make this distinction when trades occur infrequently or where prices are not transparent, such as in the fixed-income market where no spread is published.1009  
	Many commenters expressed particular concern about the proposed requirement’s application to specific markets, including: the fixed-income markets;1010 the markets for commodities, derivatives, securitized products, and emerging market securities;1011 equity and physical commodity derivatives markets;1012 and customized swaps used by customers of banking entities for hedging purposes.1013  Another commenter expressed general concern about extremely volatile markets, where market makers often see large upward or downward price swings over time.1014  
	Two commenters emphasized that the revenues a market maker generates from hedging the positions it holds in inventory are equivalent to spreads in many markets.  These commenters explained that, under these circumstances, a market maker generates revenue from the difference between the customer price for the position and the banking entity’s price for the hedge.  The commenters noted that proposed Appendix B expressly recognizes this in the case of derivatives and recommended that Appendix B’s guidance on this point apply equally to certain non-derivative positions.1015
	A few commenters questioned how this requirement would work in the context of block trading or otherwise facilitating large trades, where a market maker may charge a premium or discount for taking on a large position to provide “immediacy” to its customer.1016  One commenter further explained that explicitly quoted bid-ask spreads are only valid for indicated trade sizes that are modest enough to have negligible market impact, and such spreads cannot be used for purposes of a significantly larger trade.1017  	
    iv. Suggested modifications to the proposed requirement
	To address some or all of the concerns discussed above, many commenters recommended that the source of revenue requirement be modified1018 or removed from the rule entirely.1019  With respect to suggested changes, some commenters stated that the Agencies should modify the rule text,1020 use a metrics-based approach to focus on customer revenues,1021 or replace the proposed requirement with guidance.1022  Some commenters requested that the Agencies modify the focus of the requirement so that, for example, dealers’ market-making activities in illiquid securities can function as close to normal as possible1023 or market makers can take short-term positions that may ultimately result in a profit or loss.1024  As discussed below, some commenters stated that the Agencies should modify the proposed requirement to place greater restrictions on market maker revenue. 
    v. General support for the proposed requirement or for placing greater restrictions on a market maker’s sources of revenue

	Some commenters expressed support for the proposed source of revenue requirement or stated that the requirement should be more restrictive.1025  For example, one of these commenters stated that a real market maker’s trading book should be fully hedged, so it should not generate profits in excess of fees and commissions except in times of rare and extraordinary market conditions.1026  According to another commenter, the final rule should make it clear that banking entities seeking to rely on the market-making exemption may not generally seek to profit from price movements in their inventories, although their activities may give rise to modest and relatively stable profits arising from their limited inventory.1027  One commenter recommended that the proposed requirement be interpreted to limit market making in illiquid positions because a banking entity cannot have the required revenue motivation when it enters into a position for which there is no readily discernible exit price.1028
	Further, some commenters suggested that the Agencies remove the word “primarily” from the provision to limit banking entities to specified sources of revenue.1029  In addition, one of these commenters requested that the Agencies restrict a market maker’s revenue to fees and commissions and remove the allowance for revenue from bid-ask spreads because generating bid-ask revenues relies exclusively on changes in market values of positions held in inventory.1030  For enforcement purposes, a few commenters suggested that the Agencies require banking entities to disgorge any profit obtained from price appreciation.1031  
                                c. Final rule’s approach to assessing revenues
Unlike the proposed rule, the final rule does not include a requirement that a trading desk’s market making-related activity be designed to generate revenue primarily from fees, commissions, bid-ask spreads, or other income not attributable to appreciation in the value of a financial instrument or hedging.1032  The revenue requirement was one of the most commented upon aspects of the market-making exemption in the proposal.1033  
The Agencies believe that an analysis of patterns of revenue generation and profitability can help inform a judgment regarding whether trading activity is consistent with the intermediation and liquidity services that a market maker provides to its customers in the context of the liquidity, maturity, and depth of the relevant market, as opposed to prohibited proprietary trading activities.  To facilitate this type of analysis, the Agencies have included a metrics data reporting requirement that is refined from the proposed metric regarding profits and losses.  The Comprehensive Profit and Loss Attribution metric collects information regarding the daily fluctuation in the value of a trading desk’s positions to various sources, along with its volatility, including:  (i) profit and loss attributable to current positions that were also held by the banking entity as of the end of the prior day (“existing positions); (ii) profit and loss attributable to new positions resulting from the current day’s trading activity (“new positions”); and (iii) residual profit and loss that cannot be specifically attributed to existing positions or new positions.1034  
This quantitative measurement has certain conceptual similarities to the proposed source of revenue requirement in § __.4(b)(2)(v) of the proposed rule and certain of the proposed quantitative measurements.1035  However, in response to comments on those provisions, the Agencies have determined to modify the focus from particular revenue sources (e.g., fees, commissions, bid-ask spreads, and price appreciation) to when the trading desk generates revenue from its positions.  The Agencies recognize that when the trading desk is engaged in market making-related activities, the day one profit and loss component of the Comprehensive Profit and Loss Attribution metric may reflect customer-generated revenues, like fees, commissions, and spreads (including embedded premiums or discounts), as well as that day’s changes in market value.  Thereafter, profit and loss associated with the position carried in the trading desk’s book may reflect changes in market price until the position is sold or unwound.  The Agencies also recognize that the metric contains a residual component for profit and loss that cannot be specifically attributed to existing positions or new positions.  
The Agencies believe that evaluation of the Comprehensive Profit and Loss Attribution metric could provide valuable information regarding patterns of revenue generation by market-making trading desks involved in market-making activities that may warrant further review of the desk’s activities, while eliminating the requirement from the proposal that the trading desk demonstrate that its primary source of revenue, under all circumstances, is fees, commissions and bid/ask spreads.  This modified focus will reduce the burden associated with the proposed source of revenue requirement and better account for the varying depth and liquidity of markets.1036  In addition, the Agencies believe these modifications appropriately address commenters’ concerns about the proposed source of revenue requirement and reduce the potential for negative market impacts of the proposed requirement cited by commenters, such as incentives to widen spreads or disincentives to engage in market making in less liquid markets.1037   
The Agencies recognize that this analysis is only informative over time, and should not be determinative of an analysis of whether the amount, types, and risks of the financial instruments in the trading desk’s market-maker inventory are designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties.  The Agencies believe this quantitative measurement provides appropriate flexibility to obtain information on market-maker revenues, which is designed to address commenters’ concerns about the proposal’s source of revenue requirement (e.g., the burdens associated with differentiating spread revenue from price appreciation revenue) while also helping assess patterns of revenue generation that may be informative over time about whether a market maker’s activities are designed to facilitate and provide customer intermediation.  
                            8. Appendix B of the proposed rule	
                                a. Proposed Appendix B requirement
	The proposed market-making exemption would have required that the market making-related activities of the trading desk or other organizational unit of the banking entity be consistent with the commentary in proposed Appendix B.1038  In this proposed Appendix, the Agencies provided overviews of permitted market making-related activity and prohibited proprietary trading activity.1039
The proposed Appendix also set forth various factors that the Agencies proposed to use to help distinguish prohibited proprietary trading from permitted market making-related activity.  More specifically, proposed Appendix B set forth six factors that, absent explanatory facts and circumstances, would cause particular trading activity to be considered prohibited proprietary trading activity and not permitted market making-related activity.  The proposed factors focused on: (i) retaining risk in excess of the size and type required to provide intermediation services to customers (“risk management factor”); (ii) primarily generating revenues from price movements of retained principal positions and risks, rather than customer revenues (“source of revenues factor”); (iii) generating only very small or very large amounts of revenue per unit of risk, not demonstrating consistent profitability, or demonstrating high earnings volatility (“revenues relative to risk factor”); (iv) not trading through a trading system that interacts with orders of others or primarily with customers of the banking entity’s market-making desk to provide liquidity services, or retaining principal positions in excess of reasonably expected near term customer demands (“customer-facing activity factor”); (v) routinely paying rather than earning fees, commissions, or spreads (“payment of fees, commissions, and spreads factor”); and (vi) providing compensation incentives to employees that primarily reward proprietary risk-taking (“compensation incentives factor”).1040
                                b. Comments on proposed Appendix B 
	Commenters expressed differing views about the accuracy of the commentary in proposed Appendix B and the appropriateness of including such commentary in the rule.  For example, some commenters stated that the description of market making-related activity in the proposed appendix is accurate1041 or appropriately accounts for differences among asset classes.1042  Other commenters indicated that the appendix is too strict or narrow.1043  Some commenters recommended that the Agencies revise proposed Appendix B’s approach by, for example, placing greater focus on what market making is rather than what it is not,1044 providing presumptions of activity that will be treated as permitted market making-related activity,1045 re-formulating the appendix as nonbinding guidance,1046 or moving certain requirements of the proposed exemption to the appendix.1047  One commenter suggested the Agencies remove Appendix B from the rule and instead use the conformance period to analyze and develop a body of supervisory guidance that appropriately characterizes the nature of market making-related activity.1048 
	A few commenters expressed concern about the appendix’s facts-and-circumstances-based approach to distinguishing between prohibited proprietary trading and permitted market making-related activity and stated that such an approach will make it more difficult or burdensome for banking entities to comply with the proposed rule1049 or will generate regulatory uncertainty.1050  As discussed below, other commenters opposed proposed Appendix B because of its level of granularity1051 or due to perceived restrictions on interdealer trading or generating revenue from retained principal positions or risks in the proposed appendix.1052  A number of commenters expressed concern about the complexity or prescriptiveness of the six proposed factors for distinguishing permitted market making-related activity from prohibited proprietary trading.1053 
	With respect to the level of granularity of proposed Appendix B, a number of commenters expressed concern that the reference to a “single significant transaction” indicated that the Agencies will review compliance with the proposed market-making exemption on a trade-by-trade basis and stated that assessing compliance at the level of individual transactions would be unworkable.1054  One of these commenters further stated that assessing compliance at this level of granularity would reduce a market maker’s willingness to execute a customer sell order as principal due to concern that the market maker may not be able to immediately resell such position.  The commenter noted that this chilling effect would be heightened in declining markets.1055
	A few commenters interpreted certain statements in proposed Appendix B as limiting interdealer trading and expressed concerns regarding potential limitations on this activity.1056  These commenters emphasized that market makers may need to trade with non-customers to: (i) provide liquidity to other dealers and, indirectly, their customers, or to otherwise allow customers to access a larger pool of liquidity;1057 (ii) conduct price discovery to inform the prices a market maker can offer to customers;1058 (iii) unwind or sell positions acquired from customers;1059 (iv) establish or acquire positions to meet reasonably expected near term customer demand;1060 (v) hedge;1061 and (vi) sell a financial instrument when there are more buyers than sellers for the instrument at that time.1062  Further, one of these commenters expressed the view that the proposed appendix’s statements are inconsistent with the statutory market-making exemption’s reference to “counterparties.”1063
	In addition, a few commenters expressed concern about statements in proposed Appendix B about a market maker’s source of revenue.1064  According to one commenter, the statement that profit and loss generated by inventory appreciation or depreciation must be “incidental” to customer revenues is inconsistent with market making-related activity in less liquid assets and larger transactions because market makers often must retain principal positions for longer periods of time in such circumstances and are unable to perfectly hedge these positions.1065  As discussed above with respect to the source of revenue requirement in § __.4(b)(v) of the proposed rule, a few commenters requested that Appendix B’s discussion of “customer revenues” be modified to state that revenues from hedging will be considered to be customer revenues in certain contexts beyond derivatives contracts.1066
	A number of commenters discussed the six proposed factors in Appendix B that, absent explanatory facts and circumstances, would have caused a particular trading activity to be considered prohibited proprietary trading activity and not permitted market making-related activity.1067  With respect to the proposed factors, one commenter indicated that they are appropriate,1068 while another commenter stated that they are complex and their effectiveness is uncertain.1069  Another commenter expressed the view that “[w]hile each of the selected factors provides evidence of ‘proprietary trading,’ warrants regulatory attention, and justifies a shift in the burden of proof, some require subjective judgments, are subject to gaming or data manipulation, and invite excessive reliance on circumstantial evidence and lawyers’ opinions.”1070  
	In response to the proposed risk management factor,1071 one commenter expressed concern that it could prevent a market maker from warehousing positions in anticipation of predictable but unrealized customer demands and, further, could penalize a market maker that misestimated expected demand.  This commenter expressed the view that such an outcome would be contrary to the statute and would harm market liquidity.1072  Another commenter requested that this presumption be removed because in less liquid markets, such as markets for corporate bonds, equity derivatives, securitized products, emerging markets, foreign exchange forwards, and fund-linked products, a market maker needs to act as principal to facilitate client requests and, as a result, will be exposed to risk.1073
	Two commenters expressed concern about the proposed source of revenue factor.1074  One commenter stated that this factor does not accurately reflect how market making occurs in a majority of markets and asset classes.1075  The other commenter expressed concern that this factor shifted the emphasis of § __.4(b)(v) of the proposed rule, which required that market making-related activities be “designed” to generate revenue primarily from certain sources, to the actual outcome of activities.1076 
	With respect to the proposed revenues relative to risk factor, one commenter supported this aspect of the proposal.1077  Some commenters, however, expressed concern about using these factors to differentiate permitted market making-related activity from prohibited proprietary trading.1078  These commenters stated that volatile risk-taking and revenue can be a natural result of principal market-making activity.1079  One commenter noted that customer flows are often “lumpy” due to, for example, a market maker’s facilitation of large trades.1080  
	A few commenters indicated that the analysis in the proposed customer-facing activity factor may not accurately reflect how market making occurs in certain markets and asset classes due to potential limitations on interdealer trading.1081  According to another commenter, however, a banking entity’s non-customer facing trades should be required to be matched with existing customer counterparties.1082  With respect to the near term customer demand component of this factor, one commenter expressed concern that it goes farther than the statute’s activity-based “design” test by analyzing whether a trading unit’s inventory has exceeded reasonably expected near term customer demand at any particular point in time.1083 
	Some commenters expressed concern about the payment of fees, commissions, and spreads factor. 1084  One commenter appeared to support this proposed factor.1085  According to one commenter, this factor fails to recognize that market makers routinely pay a variety of fees in connection with their market making-related activity, including, for example, fees to access liquidity on another market to satisfy customer demand, transaction fees as a matter of course, and fees in connection with hedging transactions.  This commenter also indicated that, because spreads in current, rapidly-moving markets are volatile, short-term measurements of profit compared to spread revenue is problematic, particularly for less liquid stocks.1086  Another commenter stated that this factor reflects a bias toward agency trading and principal market making in highly liquid, exchange-traded markets and does not reflect the nature of principal market making in most markets.1087  One commenter recommended that the rule require that a trader who pays a fee be prepared to document the chain of custody to show that the instrument is shortly re-sold to an interested customer.1088
Regarding the proposed compensation incentives factor, one commenter requested that the Agencies make clear that explanatory facts and circumstances cannot justify a trading unit providing compensation incentives that primarily reward proprietary risk-taking to employees engaged in market making.  In addition, the commenter recommended that the Agencies delete the word “primarily” from this factor.1089
                                c. Determination to not adopt proposed Appendix B
To improve clarity, the final rule establishes particular criteria for the exemption and does not incorporate the commentary in proposed Appendix B regarding the identification of permitted market making-related activities.  This Supplementary Information provides guidance on the standards for compliance with the market-making exemption.
                            9. Use of quantitative measurements
Consistent with the FSOC study and the proposal, the Agencies continue to believe that quantitative measurements can be useful to banking entities and the Agencies to help assess the profile of a trading desk’s trading activity and to help identify trading activity that may warrant a more in-depth review.1090  The Agencies will not use quantitative measurements as a dispositive tool for differentiating between permitted market making-related activities and prohibited proprietary trading.  Like the framework the Agencies have developed for the market-making exemption, the Agencies recognize that there may be differences in the quantitative measurements across markets and asset classes.
            4. Section __.5:  Permitted Risk-Mitigating Hedging Activities.
Section __.5 of the proposed rule implemented section 13(d)(1)(C) of the BHC Act, which provides an exemption from the prohibition on proprietary trading for certain risk-mitigating hedging activities.1091  Section 13(d)(1)(C) provides an exemption for risk-mitigating hedging activities in connection with and related to individual or aggregated positions, contracts, or other holdings of a banking entity that are designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings (the “hedging exemption”).  Section __.5 of the final rule implements the hedging exemption with a number of modifications from the proposed rule to respond to commenters’ concerns as described more fully below.
                a. Summary of Proposal’s Approach to Implementing the Hedging Exemption	
The proposed rule would have required seven criteria to be met in order for a banking entity’s activity to qualify for the hedging exemption.  First, §§ __.5(b)(1) and __.5(b)(2)(i) of the proposed rule generally required that the banking entity establish an internal compliance program that is designed to ensure the banking entity’s compliance with the requirements of the hedging limitations, including reasonably designed written policies and procedures, internal controls, and independent testing, and that a transaction for which the banking entity is relying on the hedging exemption be made in accordance with the compliance program established under § __.5(b)(1).  Next, § __.5(b)(2)(ii) of the proposed rule required that the transaction hedge or otherwise mitigate one or more specific risks, including market risk, counterparty or other credit risk, currency or foreign exchange risk, interest rate risk, basis risk, or similar risks, arising in connection with and related to individual or aggregated positions, contracts, or other holdings of the banking entity.  Moreover, § __.5(b)(2)(iii) of the proposed rule required that the transaction be reasonably correlated, based upon the facts and circumstances of the underlying and hedging positions and the risks and liquidity of those positions, to the risk or risks the transaction is intended to hedge or otherwise mitigate.  Furthermore, § __.5(b)(2)(iv) of the proposed rule required that the hedging transaction not give rise, at the inception of the hedge, to significant exposures that are not themselves hedged in a contemporaneous transaction.  Section __.5(b)(2)(v) of the proposed rule required that any hedge position established in reliance on the hedging exemption be subject to continuing review, monitoring and management.  Finally, § __.5(b)(2)(vi) of the proposed rule required that the compensation arrangements of persons performing the risk-mitigating hedging activities be designed not to reward proprietary risk-taking.  Additionally, § __.5(c) of the proposed rule required the banking entity to document certain hedging transactions at the time the hedge is established.
                a. Manner of Evaluating Compliance with the Hedging Exemption
A number of commenters expressed concern that the final rule required application of the hedging exemption on a trade-by-trade basis.1092  One commenter argued that the text of the proposed rule seemed to require a trade-by-trade analysis because each “purchase or sale” or “hedge” was subject to the requirements.1093  The final rule modifies the proposal by generally replacing references to a “purchase or sale” in the § __.5(b) requirements with “risk-mitigating hedging activity.”  The Agencies believe this approach is consistent with the statute, which refers to “risk-mitigating hedging activity.”1094
Section 13(d)(1)(C) of the BHC Act specifically authorizes risk-mitigating hedging activities in connection with and related to “individual or aggregated positions, contracts or other holdings.”1095  Thus, the statute does not require that exempt hedging be conducted on a trade-by-trade basis, and permits hedging of aggregated positions.  The Agencies recognized this in the proposed rule, and the final rule continues to permit hedging activities in connection with and related to individual or aggregated positions.
The statute also requires that, to be exempt under section 13(d)(1)(C), hedging activities be risk-mitigating. The final rule incorporates this statutory requirement.  As explained in more detail below, the final rule requires that, in order to qualify for the exemption for risk-mitigating hedging activities: the banking entity implement, maintain, and enforce an internal compliance program, including policies and procedures that govern and control these hedging activities; the hedging activity be designed to reduce or otherwise significantly mitigate and demonstrably reduces or otherwise significantly mitigates specific, identifiable risks; the hedging activity not give rise to significant new risks that are left unhedged; the hedging activity be subject to continuing review, monitoring and management to address risk that might develop over time; and the compensation arrangements for persons performing risk-mitigating hedging activities be designed not to reward or incentivize prohibited proprietary trading.  These requirements are designed to focus the exemption on hedging activities that are designed to reduce risk and that also demonstrably reduce risk, in accordance with the requirement under section 13(d)(1)(C) that hedging activities be risk-mitigating to be exempt.  Additionally, the final rule imposes a documentation requirement on certain types of hedges.  
Consistent with the other exemptions from the ban on proprietary trading for market-making and underwriting, the Agencies intend to evaluate whether an activity complies with the hedging exemption under the final rule based on the totality of circumstances involving the products, techniques, and strategies used by a banking entity as part of its hedging activity.1096  
                b. Comments on the Proposed Rule and Approach to Implementing the Hedging Exemption.	
Commenters expressed a variety of views on the proposal’s hedging exemption.  A few commenters offered specific suggestions described more fully below regarding how, in their view, the hedging exemption should be strengthened to ensure proper oversight of hedging activities.1097  These commenters expressed concern that the proposal’s exemption was too broad and argued that all proprietary trading could be designated as a hedge under the proposal and thereby evade the prohibition of section 13.1098 
By contrast, a number of other commenters argued that the proposal imposed burdensome requirements that were not required by statute, would limit the ability of banking entities to hedge in a prudent and cost-effective manner, and would reduce market liquidity.1099  These commenters argued that implementation of the requirements of the proposal would decrease safety and soundness of banking entities and the financial system by reducing cost-effective risk management options.  Some commenters emphasized that the ability of banking entities to hedge their positions and manage risks taken in connection with their permissible activities is a critical element of liquid and efficient markets, and that the cumulative impact of the proposal would inhibit this risk-mitigation by raising transaction costs and suppressing essential and beneficial hedging activities.1100  
A number of commenters expressed concern that the proposal’s hedging exemption did not permit the full breadth of transactions in which banking entities engage to hedge or mitigate risks, such as portfolio hedging,1101 dynamic hedging,1102 anticipatory hedging, 1103 or scenario hedging.1104  Some commenters stated that restrictions on a banking entity’s ability to hedge may have a chilling effect on its willingness to engage in other permitted activities, such as market making.1105  In addition, many of these commenters stated that, if a banking entity is limited in its ability to hedge its market-making inventory, it may be less willing or able to assume risk on behalf of customers or provide financial products to customers that are used for hedging purposes.  As a result, according to these commenters, it will be more difficult for customers to hedge their risks and customers may be forced to retain risk.1106  
Another commenter contended that the proposal represented an inappropriate “one-size-fits-all” approach to hedging that did not properly take into account the way banking entities and especially market intermediaries operate, particularly in less-liquid markets.1107  Two commenters requested that the Agencies clarify that a banking entity may use its discretion to choose any hedging strategy that meets the requirements of the proposed exemption and, in particular, that a banking entity is not obligated to choose the “best hedge” and may use the cheapest instrument available.1108  One commenter suggested uncertainty about the permissibility of a situation where gains on a hedge position exceed losses on the underlying position.  The commenter suggested that uncertainty may lead banking entities to not use the most cost-effective hedge, which would make hedging less efficient and raise costs for banking entities and customers.1109  However, another commenter expressed concern about banking entities relying on the cheapest satisfactory hedge.  The commenter explained that such hedges lead to more complicated risk profiles and require banking entities to engage in additional transactions to hedge the exposures resulting from the imperfect, cheapest hedge.1110
A few commenters suggested the hedging exemption be modified in favor of a simpler requirement that banking entities adopt risk limits and policies and procedures commensurate with qualitative guidance issued by the Agencies.1111  Many of these commenters also expressed concerns that the proposed rule’s hedging exemption would not allow so-called asset-liability management (“ALM”) activities.1112  Some commenters proposed that the risk-mitigating hedging exemption reference a set of relevant descriptive factors rather than specific prescriptive requirements.1113  Other alternative frameworks suggested by commenters include: (i) reformulating the proposed requirements as supervisory guidance;1114 (ii) establishing a safe harbor,1115 presumption of compliance,1116 or bright line test;1117 or (iii) a principles-based approach that would require a banking entity to document its risk-mitigating hedging strategies for submission to its regulator.1118  
                c. Final Rule
The final rule provides a multi-faceted approach to implementing the hedging exemption that seeks to ensure that hedging activity is designed to be risk-reducing in nature and not designed to mask prohibited proprietary trading.1119  The final rule includes a number of modifications in response to comments.  
This multi-faceted approach is intended to permit hedging activities that are risk-mitigating and to limit potential abuse of the hedging exemption while not unduly constraining the important risk-management function that is served by a banking entity’s hedging activities.  This approach is also intended to ensure that any banking entity relying on the hedging exemption has in place appropriate internal control processes to support its compliance with the terms of the exemption.  While commenters proposed a number of alternative frameworks for the hedging exemption, the Agencies believe the final rule’s multi-faceted approach most effectively balances commenter concerns with statutory purpose.  In response to commenter requests to reformulate the proposed rule as supervisory guidance,1120 including the suggestion that the Agencies simply require banking entities to adopt risk limits and policies and procedures commensurate with qualitative Agency guidance,1121 the Agencies believe that such an approach would provide less clarity than the adopted approach.  Although a purely guidance-based approach could provide greater flexibility, it would also provide less specificity, which could make it difficult for banking entity personnel and the Agencies to determine whether an activity complies with the rule and could lead to an increased risk of evasion of the statutory requirements.  Further, while a bright-line or safe harbor approach to the hedging exemption would generally provide a high degree of certainty about whether an activity qualifies for the exemption, it would also provide less flexibility to recognize the differences in hedging activity across markets and asset classes.1122  In addition, the use of any bright-line approach would more likely be subject to gaming and avoidance as new products and types of trading activities are developed than other approaches to implementing the hedging exemption.  Similarly, the Agencies decline to establish a presumption of compliance because, in light of the constant innovation of trading activities and the differences in hedging activity across markets and asset classes, establishing appropriate parameters for a presumption of compliance with the hedging exemption would potentially be less capable of recognizing these legitimate differences than our current approach.1123  Moreover, the Agencies decline to follow a principles-based approach requiring a banking entity to document its hedging strategies for submission to its regulator.1124  The Agencies believe that evaluating each banking entity’s trading activity based on an individualized set of documented hedging strategies could be unnecessarily burdensome and result in unintended competitive impacts since banking entities would not be subject to one uniform rule.  The Agencies believe the multi-faceted approach adopted in the final rule establishes a consistent framework applicable to all banking entities that will reduce the potential for such adverse impacts.  
Further, the Agencies believe the scope of the final hedging exemption is appropriate because it permits risk-mitigating hedging activities, as mandated by section 13 of the BHC Act,1125 while requiring a robust compliance program and other internal controls to help ensure that only genuine risk-mitigating hedges can be used in reliance on the exemption.1126  In response to concerns that the proposed hedging exemption would reduce legitimate hedging activity and thus impact market liquidity and the banking entity’s willingness to engage in permissible customer-related activity,1127 the Agencies note that the requirements of the final hedging exemption are designed to permit banking entities to properly mitigate specific risk exposures, consistent with the statute.  In addition, hedging related to market-making activity conducted by a market-making desk is subject to the requirements of the market-making exemption, which are designed to permit banking entities to continue providing valuable intermediation and liquidity services, including related risk-management activity.1128  Thus, the final hedging exemption will not negatively impact the safety and soundness of banking entities or the financial system or have a chilling effect on a banking entity’s willingness to engage in other permitted activities, such as market making.1129
These limits and requirements are designed to prevent the type of activity conducted by banking entities in the past that involved taking large positions using novel strategies to attempt to profit from potential effects of general economic or market developments and thereby potentially offset the general effects of those events on the revenues or profits of the banking entity.  The documentation requirements in the final rule support these limits by identifying activity that occurs in reliance on the risk-mitigating hedging exemption at an organizational level or desk that is not responsible for establishing the risk or positions being hedged.
                            1. Compliance program requirement 
The first criterion of the proposed hedging exemption required a banking entity to establish an internal compliance program designed to ensure the banking entity’s compliance with the requirements of the hedging exemption and conduct its hedging activities in compliance with that program.  While the compliance program under the proposal was expected to be appropriate for the size, scope, and complexity of each banking entity’s activities and structure, the proposal would have required each banking entity with significant trading activities to implement robust, detailed hedging policies and procedures and related internal controls and independent testing designed to prevent prohibited proprietary trading in the context of permitted hedging activity.1130  These enhanced programs for banking entities with large trading activity were expected to include written hedging policies at the trading unit level and clearly articulated trader mandates for each trader designed to ensure that hedging strategies mitigated risk and were not for the purpose of engaging in prohibited proprietary trading.  
Commenters, including industry groups, generally expressed support for requiring policies and procedures to monitor the safety and soundness, as well as appropriateness, of hedging activity.1131  Some of these commenters advocated that the final rule presume that a banking entity is in compliance with the hedging exemption if the banking entity’s hedging activity is done in accordance with the written policies and procedures required under its compliance program.1132  One commenter represented that the proposed compliance framework was burdensome and complex.1133
Other commenters expressed concerns that the hedging exemption would be too limiting and burdensome for community and regional banks.1134  Some commenters argued that foreign banking entities should not be subject to the requirements of the hedging exemption for transactions that do not introduce risk into the U.S. financial system.1135  Other commenters stated that coordinated hedging through and by affiliates should qualify as permitted risk-mitigating hedging activity.1136  
Some commenters urged the Agencies to adopt detailed limitations on hedging activities.  For example, one commenter urged that all hedging trades be labeled as such at the inception of the trade and detailed information regarding the trader, manager, and supervisor authorizing the trade be kept and reviewed.1137  Another commenter suggested that the hedging exemption contain a requirement that the banking entity employee who approves a hedge affirmatively certify that the hedge conforms to the requirements of the rule and has not been put in place for the direct or indirect purpose or effect of generating speculative profits.1138  A few commenters requested limitations on instruments that can be used for hedging purposes.1139
The final rule retains the proposal’s requirement that a banking entity establish an internal compliance program that is designed to ensure the banking entity limits its hedging activities to hedging that is risk-mitigating.1140  The final rule largely retains the proposal’s approach to the compliance program requirement, except to the extent that, as requested by some commenters,1141 the final rule modifies the proposal to provide additional detail regarding the elements that must be included in a compliance program. Similar to the proposal, the final rule contemplates that the scope and detail of a compliance program will reflect the size, activities, and complexity of banking entities in order to ensure that banking entities engaged in more active trading have enhanced compliance programs without imposing undue burden on smaller organizations and entities that engage in little or no trading activity.1142  The final rule also requires, like the proposal, that the banking entity implement, maintain, and enforce the program.1143  
In response to commenter concerns about ensuring the appropriate level of senior management involvement in establishing these policies,1144 the final rule requires that the written policies and procedures be developed and implemented by a banking entity at the appropriate level of organization and expressly address the banking entity’s requirements for escalation procedures, supervision, and governance related to hedging activities.1145  
Like the proposal, the final rule specifies that a banking entity’s compliance regime must include reasonably designed written policies and procedures regarding the positions, techniques and strategies that may be used for hedging, including documentation indicating what positions, contracts or other holdings a trading desk may use in its risk-mitigating hedging activities.1146  The focus on policies and procedures governing risk identification and mitigation, analysis and testing of position limits and hedging strategies, and internal controls and ongoing monitoring is expected to limit use of the hedging exception to risk-mitigating hedging.  The final rule adds to the proposed compliance program approach by requiring that the banking entity’s written policies and procedures include position and aging limits with respect to such positions, contracts, or other holdings.1147  The final rule, similar to the proposed rule, also requires that the compliance program contain internal controls and ongoing monitoring, management, and authorization procedures, including relevant escalation procedures.1148  Further, the final rule retains the proposed requirement that the compliance program provide for the conduct of analysis and independent testing designed to ensure that the positions, techniques, and strategies that may be used for hedging may reasonably be expected to demonstrably reduce or otherwise significantly mitigate the specific, identifiable risks being hedged.1149  
The final rule also adds that correlation analysis be undertaken as part of the analysis of the hedging positions, techniques, and strategies that may be used. This provision effectively changes the requirement in the proposed rule that the hedge must maintain correlation into a requirement that correlation be analyzed as part of the compliance program before a hedging activity is undertaken.  This provision incorporates the concept in the proposed rule that a hedge should be correlated (negatively, when sign is considered) to the risk being hedged.  However, the Agencies recognize that some effective hedging activities, such as deep out-of-the-money puts and calls, may not be exhibit a strong linear correlation to the risks being hedged and also that correlation over a period of time between two financial positions does not necessarily mean one position will in fact reduce or mitigate a risk of the other.  Rather, the Agencies expect the banking entity to undertake a correlation analysis that will, in many but not all instances, provide a strong indication of whether a potential hedging position, strategy, or technique will or will not demonstrably reduce the risk it is designed to reduce.  It is important to recognize that the rule does not require the banking entity to prove correlation mathematically or by other specific methods.  Rather, the nature and extent of the correlation analysis undertaken would be dependent on the facts and circumstances of the hedge and the underlying risks targeted.  If correlation cannot be demonstrated, then the Agencies would expect that such analysis would explain why not and also how the proposed hedging position, technique, or strategy is designed to reduce or significantly mitigate risk and how that reduction or mitigation can be demonstrated without correlation.
Moreover, the final rule requires hedging activity conducted in reliance on the hedging exemption be subject to continuing review, monitoring, and management that is consistent with the banking entity’s written hedging policies and procedures and is designed to reduce or otherwise significantly mitigate, and demonstrably reduces or otherwise significantly mitigates, the specific, identifiable risks that develop over time from hedging activity and underlying positions.1150  This ongoing review should consider market developments, changes in positions or the configuration of aggregated positions, changes in counterparty risk, and other facts and circumstances related to the risks associated with the underlying and hedging positions, contracts, or other holdings.  
The Agencies believe that requiring banking entities to develop and follow detailed compliance policies and procedures related to risk-mitigating hedging activity will help both banking entities and examiners understand the risks to which banking entities are exposed and how these risks are managed in a safe and sound manner.  With this increased understanding, banking entities and examiners will be better able to evaluate whether banking entities are engaged in legitimate, risk-reducing hedging activity, rather than impermissible proprietary trading.  While the Agencies recognize there are certain costs associated with this compliance program requirement,1151 we believe this provision is necessary to ensure compliance with the statute and the final rule.  As discussed in Part IV.C.1., the Agencies have modified the proposed compliance program structure to reduce burdens on small banking entities.1152  
The Agencies note that hedging may occur across affiliates under the hedging exemption.1153  To ensure that hedging across trading desks or hedging done at a level of the organization outside of the trading desk does not result in prohibited proprietary trading, the final rule imposes enhanced documentation requirements on these activities, which are discussed more fully below.  The Agencies also note that nothing in the final rule limits or restricts the ability of the appropriate supervisory agency of a banking entity to place limits on interaffiliate hedging in a manner consistent with their safety and soundness authority to the extent the agency has such authority.1154  Additionally, nothing in the final rule limits or modifies the applicability of CFTC regulations with respect to the clearing of interaffiliate swaps.1155   
                            2. Hedging of specific risks and demonstrable reduction of risk
Section __.5(b)(2)(ii) of the proposed rule required that a qualifying transaction hedge or otherwise mitigate one or more specific risks, including market risk, counterparty or other credit risk, currency or foreign exchange risk, interest rate risk, basis risk, or similar risks, arising in connection with and related to individual or aggregated positions, contracts, or other holdings of a banking entity.1156  This criterion implemented the essential element of the hedging exemption that the transaction be risk-mitigating.  
Some commenters expressed support for this provision, particularly the requirement that a banking entity be able to tie a hedge to a specific risk.1157  One of these commenters stated that a demonstrated reduction in risk should be a key indicator of whether a hedge is in fact permitted.1158  However, some commenters argued that the list of risks eligible to be hedged under the proposed rule, which included risks arising from aggregated positions, could justify transactions that should be viewed as prohibited proprietary trading.1159  Another commenter contended that the term “basis risk” was undefined and could heighten the potential that this exemption would be used to evade the prohibition on proprietary trading.1160
 Other commenters argued that requiring a banking entity to specify the particular risk being hedged discourages effective hedging and increases the risk at banking entities.  These commenters contended that hedging activities must address constantly changing positions and market conditions.1161  Another commenter argued that this requirement could render a banking entity’s hedges impermissible if those hedges do not succeed in fully hedging or mitigating an identified risk as determined by a post hoc analysis and could prevent banking entities from entering into hedging transactions in anticipation of risks that the banking entity expects will arise (or increase).1162  Certain commenters requested that the hedging exemption provide a safe harbor for positions that satisfy FASB ASC Topic 815 (formerly FAS 133) hedging accounting standards, which provides that an entity recognize derivative instruments, including certain derivative instruments embedded in other contracts, as assets or liabilities in the statement of financial position and measure them at fair value.1163  Another commenter suggested that scenario hedges could be identifiable and subject to review by the Agencies using VaR, Stress VaR, and VaR Exceedance, as well as revenue metrics.1164   
The Agencies have considered these comments carefully in light of the statute.  Section 13(d)(1)(C) of the BHC Act provides an exemption from the prohibition on proprietary trading only for hedging activity that is “designed to reduce the specific risks to the banking entity in connection with and related to” individual or aggregated positions, contracts, or other holdings of the banking entity.1165  Thus, while the statute permits hedging of individual or aggregated positions (as discussed more fully below), the statute requires that, to be exempt from the prohibition on proprietary trading, hedging transactions be designed to reduce specific risks.1166  Moreover, it requires that these specific risks be in connection with or related to the individual or aggregated positions, contracts, or other holdings of the banking entity.
The final rule implements these requirements.  To ensure that exempt hedging activities are designed to reduce specific risks, the final rule requires that the hedging activity at inception of the hedging activity, including, without limitation, any adjustments to the hedging activity, be designed to reduce or otherwise significantly mitigate and demonstrably reduces or otherwise significantly mitigates one or more specific, identifiable risks, including market risk, counterparty or other credit risk, currency or foreign exchange risk, interest rate risk, commodity price risk, basis risk, or similar risks, arising in connection with and related to identified individual or aggregated positions, contracts, or other holdings of the banking entity, based upon the facts and circumstances of the individual or aggregated underlying and hedging positions, contracts, or other holdings of the banking entity and the risks and liquidity thereof.1167  Hedging activities and limits should be based on analysis conducted by the banking entity of the appropriateness of hedging instruments, strategies, techniques, and limits.  As discussed above, this analysis must include analysis of correlation between the hedge and the specific identifiable risk or risks that the hedge is designed to reduce or significantly mitigate.1168  
This language retains the focus of the statute and the proposed rule on reducing or mitigating specific and identified risks.1169  As discussed more fully above, banking entities are required to describe in their compliance policies and procedures the types of strategies, techniques, and positions that may be used for hedging.  
The final rule does not prescribe the hedging strategy that a banking entity must employ.  While one commenter urged that the final rule require each banking entity to adopt the “best hedge” for every transaction,1170 the Agencies believe that the complexity of positions, market conditions at the time of a transaction, availability of hedging transactions, costs of hedging, and other circumstances at the time of the transaction make a requirement that a banking entity always adopt the “best hedge” impractical, unworkable, and subjective.  
Nonetheless, the statute requires that, to be exempt under section 13(d)(1)(C), hedging activity must be risk-mitigating.  To ensure that only risk-mitigating hedging is permitted under this exemption, the final rule requires that in its written policies and procedures the banking entity identify the instruments and positions that may be used in hedging, the techniques and strategies the banking entity deems appropriate for its hedging activities, as well as position limits and aging limits on hedging positions.  These written policies and procedures also must specify the escalation and approval procedures that apply if a trader seeks to conduct hedging activities beyond the limits, position types, strategies, or techniques authorized for the trader’s activities.1171
As noted above, commenters were concerned that risks associated with permitted activities and holdings change over time, making a determination regarding the effectiveness of hedging activities in reducing risk dependent on the time when risk is measured.  To address this, the final rule requires that the exempt hedging activity be designed to reduce or otherwise significantly mitigate, and demonstrably reduces or otherwise significantly mitigates, risk at the inception of the hedge.  As explained more fully below, because risks and the effectiveness of a hedging strategy may change over time, the final rule also requires the banking entity to implement a program to review, monitor, and manage its hedging activity over the period of time the hedging activity occurs in a manner designed to reduce or significantly mitigate and demonstrably reduce or otherwise significantly mitigate new or changing risks that may develop over time from both the banking entity’s hedging activities and the underlying positions.  Many commenters expressed concern that the proposed ongoing review, monitoring, and management requirement would limit a banking entity’s ability to engage in aggregated position hedging.1172  One commenter stated that because aggregated position hedging may result in modification of hedging exposures across a variety of underlying risks, even as the overall risk profile of a banking entity is reduced, it would become impossible to subsequently review, monitor, and manage individual hedging transactions for compliance.1173  The Agencies note that the final rule, like the statute, requires that the hedging activity relate to individual or aggregated positions, contracts or other holdings  being hedged, and accordingly, the review, monitoring and management requirement would not limit the extent of permitted hedging provided for in section 13(d)(1)(C) as implied by some commenters.  Further, the final rule recognizes that the determination of whether hedging activity demonstrably reduces or otherwise significantly mitigates risks that may develop over time should be “based upon the facts and circumstances of the underlying and hedging positions, contracts and other holdings of the banking entity and the risks and liquidity thereof.”1174
A number of other commenters argued that a legitimate risk-reducing hedge may introduce new risks at inception.1175  A few commenters contended that a requirement that no new risks be associated with a hedge would be inconsistent with prudent risk management and greatly reduce the ability of banking entities to reduce overall risk through hedging.1176  A few commenters stated that the proposed requirement does not recognize that it is not always possible to hedge a new risk exposure arising from a hedge in a cost-effective manner.1177  With respect to the timing of the initial hedge and any additional transactions necessary to reduce significant exposures arising from it, one of these commenters represented that requiring contemporaneous hedges is impracticable, would raise transaction costs, and would make hedging uneconomic.1178  Another commenter stated that this requirement could have a chilling effect on risk managers’ willingness to engage in otherwise permitted hedging activity.1179  
Other commenters stated that a position that does not fully offset the risk of an underlying position is not in fact a hedge.1180  These commenters believed that the introduction of new risks at inception of a transaction indicated that the transaction was impermissible proprietary trading and not a hedge.1181  
The Agencies recognize that prudent risk-reducing hedging activities by banking entities are important to the efficiency of the financial system.1182  The Agencies further recognize that hedges are generally imperfect; consequently, hedging activities can introduce new and sometimes significant risks, such as credit risk, basis risk, or new market risk, especially when hedging illiquid positions.1183  However, the Agencies also recognize that hedging activities present an opportunity to engage in impermissible proprietary trading designed to profit from exposure to these types of risks.  
To address these competing concerns, the final rule substantially retains the proposed requirement that, at the inception of the hedging activity, the risk-reducing hedging activity does not give rise to significant new or additional risk that is not itself contemporaneously hedged.  This approach is designed to allow banking entities to continue to engage in prudent risk-mitigating activities while ensuring that the hedging exemption is not used to engage in prohibited proprietary trading by taking on prohibited short-term exposures under the guise of hedging.1184  As noted in the proposal, however, the Agencies recognize that exposure to new risks may result from legitimate hedging transactions;1185 this provision only prohibits the introduction of additional significant exposures through the hedging transaction unless those additional exposures are contemporaneously hedged.
As noted above, the final rule recognizes that whether hedging activity will demonstrably reduce risk must be based upon the facts and circumstances of the individual or aggregated underlying and hedging positions, contracts, or other holdings of the banking entity and the risks and liquidity thereof.1186  The Agencies believe this approach balances commenters’ request that the Agencies clarify that a banking entity may use its discretion to choose any hedging strategy that meets the requirements of the proposed exemption1187 with concerns that allowing banking entities to rely on the cheapest satisfactory hedge will lead to additional hedging transactions.1188  The Agencies expect that hedging strategies and techniques, as well as assessments of risk, will vary across positions, markets, activities and banking entities, and that a “one-size-fits-all” approach would not accommodate all types of appropriate hedging activity.1189
By its terms, section 13(d)(1)(C) of the BHC Act permits a banking entity to engage in risk-mitigating hedging activity “in connection with and related to individual or aggregated positions . . . .”1190  The preamble to the proposed rule made clear that, consistent with the statutory reference to mitigating risks of individual or aggregated positions, this criterion permits hedging of risks associated with aggregated positions.1191  This approach is consistent with prudent risk-management and safe and sound banking practice.1192  
The proposed rule explained that, to be exempt under this provision, hedging activities must reduce risk with respect to “positions, contracts, or other holdings of the banking entity.”  The proposal also required that a banking entity relying on the exemption be prepared to identify the specific position or risks associated with aggregated positions being hedged and demonstrate that the hedging transaction was risk-reducing in the aggregate, as measured by appropriate risk management tools.
Some commenters were of the view that the hedging exemption applied to aggregated positions or portfolio hedging and was consistent with prudent risk-management practices.  These commenters argued that permitting a banking entity to hedge aggregate positions and risks arising from a portfolio of assets would be more efficient from both a procedural and business standpoint.1193  
By contrast, other commenters argued that portfolio-based hedging could be used to mask prohibited proprietary trading.1194  One commenter contended that the statute provides no basis for portfolio hedging, and another commenter similarly suggested that portfolio hedging should be prohibited.1195  Another commenter suggested adopting limits that would prevent the use of the hedging exemption to conduct proprietary activity at one desk as a theoretical “hedge for proprietary trading at another desk.” 1196  Among the limits suggested by these commenters were a requirement that a banking entity have a well-defined compliance program, the formation of central “risk management” groups to perform and monitor hedges of aggregated positions, and a requirement that the banking entity demonstrate the capacity to measure aggregate risk across the institution with precision using proven models.1197  A few commenters suggested that the presence of portfolio hedging should be viewed as an indicator of imperfections in hedging at the desk level and be a flag used by examiners to identify and review the integrity of specific hedges.1198  
The final rule, like the proposed rule, implements the statutory language providing for risk-mitigating hedging activities related to individual or aggregated positions.  For example, activity permitted under the hedging exemption would include the hedging of one or more specific risks arising from identified positions, contracts, or other holdings, such as the hedging of the aggregate risk of identified positions of one or more trading desks.  Further, the final rule requires that these hedging activities be risk-reducing with respect to the identified positions, contracts, or other holdings being hedged and that the risk reduction be demonstrable.  Specifically, the final rule requires, among other things: that the banking entity has a robust compliance program reasonably designed to ensure compliance with the exemption; that each hedge is subject to continuing review, monitoring and management designed to demonstrably reduce or otherwise significantly mitigate the specific, identifiable risks that develop over time related to the hedging activity and the underlying positions, contracts, or other holdings of the banking entity; and that the banking entity meet a documentation requirement for hedges not established by the trading desk responsible for the underlying position or for hedges effected through a financial instrument, technique or strategy that is not specifically identified in the trading desk’s written policies and procedures.  The Agencies believe this approach addresses concerns that a banking entity could use the hedging exemption to conduct proprietary activity at one desk as a theoretical hedge for proprietary trading at another desk in a manner consistent with the statute.1199  Further, the Agencies believe the adopted exemption allows banking entities to engage in hedging of aggregated positions1200 while helping to ensure that such hedging activities are truly risk-mitigating.1201
As noted above, several commenters questioned whether the hedging exemption should apply to “portfolio” hedging and whether portfolio hedging may create the potential for abuse of the hedging exemption.  The term “portfolio hedging” is not used in the statute.  The language of section 13(d)(1)(C) of the BHC Act permits a banking entity to engage in risk-mitigating hedging activity “in connection with and related to individual or aggregated positions . . . .”1202  After consideration of the comments regarding portfolio hedging, and in light of the statutory language, the Agencies are of the view that the statutory language is clear on its face that a banking entity may engage in risk-mitigating hedging in connection with aggregated positions of the banking entity.  The permitted hedging activity, when involving more than one position, contract, or other holding, must be in connection with or related to aggregated positions of the banking entity.
Moreover, hedging of aggregated positions under this exemption must be related to identifiable risks related to specific positions, contracts, or other holdings of the banking entity.  Hedging activity must mitigate one or more specific risks arising from an identified position or aggregation of positions.  The risks in this context are not intended to be more generalized risks that a trading desk or combination of desks, or the banking entity as a whole, believe exists based on non-position-specific modeling or other considerations.  For example, the hedging activity cannot be designed to: reduce risks associated with the banking entity’s assets and/or liabilities generally, general market movements or broad economic conditions; profit in the case of a general economic downturn; counterbalance revenue declines generally; or otherwise arbitrage market imbalances unrelated to the risks resulting from the positions lawfully held by the banking entity.1203  Rather, the hedging exemption permits the banking entity to engage in trading activity designed to reduce or otherwise mitigate specific, identifiable risks related to identified individual or aggregated positions that the banking entity it otherwise lawfully permitted to have.
When undertaking a hedge to mitigate the risk of an aggregation of positions, the banking entity must be able to specifically identify the risk factors arising from this set of positions.  In identifying the aggregate set of positions that is being hedged for purposes of § __.5(b)(2)(ii) and, where applicable, § __.5(c)(2)(i), the banking entity needs to identify the positions being hedged with sufficient specificity so that at any point in time, the specific financial instrument positions or components of financial instrument positions held by the banking entity that comprise the set of positions being hedged can be clearly identified.
The proposal would have permitted a series of hedging transactions designed to rebalance hedging position(s) based on changes resulting from permissible activities or from a change in the price or other characteristic of the individual or aggregated positions, contracts, or other holdings being hedged.1204  The Agencies recognized that, in such dynamic hedging, material changes in risk may require a corresponding modification to the banking entity’s current hedge positions.1205  
Some commenters questioned the risk-mitigating nature of a hedge if, at inception, that hedge contained component risks that must be dynamically managed throughout the life of the hedge.  These commenters stated that hedges that do not continuously match the risk of underlying positions are not in fact risk-mitigating hedges in the first place.1206  
On the other hand, other commenters argued that banking entities must be permitted to engage in dynamic hedging activity, such as in response to market conditions which are unforeseeable or out of the control of the banking entity,1207 and expressed concern that the limitations of the proposed rule, especially the requirement that hedging transactions “maintain a reasonable level of correlation,” might impede truly risk-reducing hedging activity.1208
A number of commenters asserted that there could be confusion over the meaning of “reasonable correlation,” which was used in the proposal as part of explaining what type of activity would qualify for the hedging exemption.  Some commenters urged requiring that there be a “high” or “strong” correlation between the hedge and the risk of the underlying asset.1209  
Other commenters indicated that uncertainty about the meaning of reasonable correlation could limit valid risk-mitigating hedging activities because the level of correlation between a hedge and the risk of the position or aggregated positions being hedged changes over time as a result of changes in market factors and conditions.1210  Some commenters represented that the proposed provision would cause certain administrative burdens1211 or may result in a reduction in market-making activities in certain asset classes.1212  A few commenters expressed concern that the reasonable correlation requirement could render a banking entity’s hedges impermissible if they do not succeed in being reasonably correlated to the relevant risk or risks based on an after-the-fact analysis that incorporates market developments that could not have been foreseen at the time the hedge was placed.  These commenters tended to favor a different approach or a type of safe harbor based on an initial determination of correlation.1213  Some commenters argued the focus of the hedging exemption should be on risk reduction and not on reasonable correlation.1214  One commenter suggested that risk management metrics such as VaR and risk factor sensitivities could be the focus for permitted hedging instead of requirements like reasonable correlation under the proposal.1215  
In consideration of commenter concerns about the proposed reasonable correlation requirement, the final rule modifies the proposal in the following key respects.  First, the final rule modifies the requirement of “reasonable correlation” by providing that the hedge demonstrably reduce or otherwise significantly mitigate specific identifiable risks.1216  This change is designed to reinforce that hedging activity should be demonstrably risk reducing or mitigating rather than simply correlated to risk.  This change acknowledges that hedges need not simply be correlated to underlying positions, and that hedging activities should be consciously designed to reduce or mitigate identifiable risks, not simply the result of pairing correlated positions, as some commenters suggested.1217  As discussed above, the Agencies do, however, recognize that correlation is often a critical element of demonstrating that a hedging activity reduces the risks it is designed to address.  Accordingly, the final rule requires that banking entities conduct correlation analysis as part of the required compliance program in order to utilize the hedging exemption.1218  The Agencies believe this change better allows consideration of the facts and circumstances of the particular hedging activity as part of the correlation analysis and therefore addresses commenters’ concerns that the proposed reasonable correlation requirement could cause administrative burdens, impede legitimate hedging activity,1219 and require an after-the-fact analysis.1220 
Second, the final rule provides that the determination of whether an activity or strategy is risk-reducing or mitigating must, in the first instance, be made at the inception of the hedging activity.  A trade that is not risk-reducing at its inception is not viewed as a hedge for purposes of the exemption in §__.5.1221 
Third, the final rule requires that the banking entity conduct analysis and independent testing designed to ensure that the positions, techniques, and strategies used for hedging are reasonably designed to reduce or otherwise mitigate the risk being hedged.  As noted above, such analysis and testing must include correlation analysis.  Evidence of negative correlation may be a strong indicator that a given hedging position or strategy is risk-reducing.  Moreover, positive correlation, in some instances, may be an indicator that a hedging position or strategy is not designed to be risk-mitigating.  The type of analysis and factors considered in the analysis should take account of the facts and circumstances, including type of position being hedged, market conditions, depth and liquidity of the market for the underlying and hedging position, and type of risk being hedged.  
The Agencies recognize that markets and risks are dynamic and that the risks from a permissible position or aggregated positions may change over time, new risks may emerge in the positions underlying the hedge and in the hedging position, new risks may emerge from the hedging strategy over time, and hedges may become less effective over time in addressing the related risk.1222  The final rule, like the proposal, continues to allow dynamic hedging.  Additionally, the final rule requires the banking entity to engage in ongoing review, monitoring, and management of its positions and related hedging activity to reduce or otherwise significantly mitigate the risks that develop over time.  This ongoing hedging activity must be designed to reduce or otherwise significantly mitigate, and must demonstrably reduce or otherwise significantly mitigate, the material changes in risk that develop over time from the positions, contracts, or other holdings intended to be hedged or otherwise mitigated in the same way, as required for the initial hedging activity.  Moreover, the banking entity is required under the final rule to support its decisions regarding appropriate hedging positions, strategies and techniques for its ongoing hedging activity in the same manner as for its initial hedging activities.  In this manner, the final rule permits a banking entity to engage in effective management of its risks throughout changing market conditions1223 while also seeking to prohibit the banking entity from taking large proprietary positions through action or inaction related to an otherwise permissible hedge.1224
As explained above, the final rule requires a banking entity relying on the hedging exemption to be able to demonstrate that the banking entity is exposed to the specific risks being hedged at the inception of the hedge and any adjustments thereto.  However, in the proposal, the Agencies requested comment on whether the hedging exemption should be available in certain cases where hedging activity begins before the banking entity becomes exposed to the underlying risk.  The Agencies proposed that the hedging exemption would be available in certain cases where the hedge is established “slightly” before the banking entity becomes exposed to the underlying risk if such anticipatory hedging activity: (i) was consistent with appropriate risk management practices; (ii) otherwise met the terms of the hedging exemption; and (iii) did not involve the potential for speculative profit.  For example, a banking entity that was contractually obligated or otherwise highly likely to become exposed to a particular risk could engage in hedging that risk in advance of actual exposure.1225 
A number of commenters argued that anticipatory hedging is a necessary and prudent activity and that the final rule should permit anticipatory hedging more broadly than did the proposed rule.1226  In particular, commenters were concerned that permitting hedging activity only if it occurs “slightly” before a risk is taken could limit hedging activities that are crucial to risk management.1227  Commenters expressed concern that the proposed approach would, among other things, make it difficult for banking entities to accommodate customer requests for transactions with specific price or size executions1228 and limit dynamic hedging activities that are important to sound risk management.1229  In addition, a number of commenters requested that the rule permit banking entities to engage in scenario hedging, a form of anticipatory hedging that addresses potential exposures to “tail risks.”1230 
Some commenters expressed concern about the proposed criterion that the hedging activity not involve the potential for speculative profit.1231  These commenters argued that the proper focus of the hedging exemption should be on the purpose of the transaction, and whether the hedge is correlated to the underlying risks being hedged (in other words, whether the hedge is effective in mitigating risk).1232  By contrast, another commenter urged the Agencies to adopt a specific metric to track realized profits on hedging activities as an indicator of prohibited arbitrage trading.1233
Like the proposal, the final rule does not prohibit anticipatory hedging.  However, in response to commenter concerns that the proposal would limit a banking entity’s ability to respond to customer requests and engage in prudent risk management, the final rule does not retain the proposed requirement discussed above that an anticipatory hedge be established “slightly” before the banking entity becomes exposed to the underlying risk and meet certain conditions.  To address commenter concerns with the statutory mandate, several parts of the final rule are designed to ensure that all hedging activities, including anticipatory hedging activities, are designed to be risk reducing and not impermissible proprietary trading activities.  For example, the final rule retains the proposed requirement that a banking entity have reasonably designed policies and procedures indicating the positions, techniques and strategies that each trading desk may use for hedging.  These policies and procedures should specifically address when anticipatory hedging is appropriate and what policies and procedures apply to anticipatory hedging.  
The final rule also requires that a banking entity relying on the hedging exemption be able to demonstrate that the hedging activity is designed to reduce or significantly mitigate, and does demonstrably reduce or otherwise significantly mitigate, specific, identifiable risks in connection with individual or aggregated positions of the banking entity.1234  Importantly, to use the hedging exemption, the final rule requires that the banking entity subject its hedging activity to continuing review, monitoring, and management that is designed to reduce or significantly mitigate specific, identifiable risks, and that demonstrably reduces or otherwise significantly mitigates identifiable risks, in connection with individual or aggregated positions of the banking entity.1235  The final rule also requires ongoing recalibration of the hedging activity by the banking entity to ensure that the hedging activity satisfies the requirements set out in § __.5(b)(2) and is not prohibited proprietary trading.  If an anticipated risk does not materialize within a limited time period contemplated when the hedge is entered into, under these provisions, the banking entity would be required to extinguish the anticipatory hedge or otherwise demonstrably reduce the risk associated with that position as soon as reasonably practicable after it is determined that the anticipated risk will not materialize.  This requirement focuses on the purpose of the hedge as a trade designed to reduce anticipated risk and not for other purposes.  The Agencies will (and expect that banking entities also will) monitor the activities of banking entities to identify prohibited trading activity that is disguised as anticipatory hedging.  
As noted above, one commenter suggested the Agencies adopt a metric to monitor the profitability of a banking entity’s hedging activity.1236  We are not adopting such a metric because we do not believe it would be useful to monitor the profit and loss associated with hedging activity in isolation without considering the profit and loss associated with the individual or aggregated positions being hedged.  For example, the commenter’s suggested metric would not appear to provide information about whether the gains arising from hedging positions offset or mitigate losses from individual or aggregated positions being hedged.
                            3. Compensation 
The proposed rule required that the compensation arrangements of persons performing risk-mitigating hedging activities be designed not to reward proprietary risk-taking.1237  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.1238
Commenters generally supported this requirement and indicated that its inclusion was very important and valuable.1239  Some commenters argued that the final rule should limit compensation based on profits derived from hedging transactions, even if those hedging transactions were in fact risk-mitigating hedges, and urged that employees be compensated instead based on success in risk mitigation at the end of the life of the hedge.1240  In contrast, other commenters argued that the compensation requirement should restrict only compensation arrangements that incentivize employees to engage in prohibited proprietary risk-taking.1241
After considering comments received on the compensation requirements of the proposed hedging exemption, 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 is also modified to make clear that rewarding or incentivizing profit making from prohibited proprietary trading is not permitted.1242  
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.1243  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 banking entity should review its compensation arrangements in light of the guidance and rules imposed by the appropriate Federal supervisor for the entity regarding compensation.1244    
                            4. Documentation requirement
Section __.5(c) of the proposed rule would have imposed a documentation requirement on certain types of hedging transactions.  Specifically, for any transaction that a banking entity conducts in reliance on the hedging exemption that involved a hedge established at a level of organization different than the level of organization establishing or responsible for the positions, contracts, or other holdings the risks of which the hedging transaction is designed to reduce, the banking entity was required, at a minimum, to document: the risk-mitigating purpose of the transaction; the risks of the individual or aggregated positions, contracts, or other holdings of a banking entity that the transaction is designed to reduce; and the level of organization that is establishing the hedge.1245  Such documentation was required to be established at the time the hedging transaction is effected.  The Agencies expressed concern in the proposal that hedging transactions established at a different level of organization than the positions being hedged may present or reflect heightened potential for prohibited proprietary trading, either at the trading desk level or at the level instituting the hedging transaction.  In other words, the further removed hedging activities are from the specific positions, contracts, or other holdings the banking entity intends to hedge, the greater the danger that such activity is not limited to hedging specific risks of individual or aggregated positions, contracts, or other holdings of the banking entity, as required by the rule.
Some commenters argued that the final rule should require comprehensive documentation for all activity conducted pursuant to the hedging exemption, regardless of where it occurs in an organization.1246  One of these commenters stated that such documentation can be easily and quickly produced by traders and noted that traders already record execution details of every trade.1247  Several commenters argued that the rule should impose a requirement that banks label all hedges at their inception and provide information regarding the specific risk being offset, the expected duration of the hedge, how it will be monitored, how it will be wound down, and the names of the trader, manager, and supervisor approving the hedge.1248
Some commenters requested that the documentation requirement be applied at a higher level of organization,1249 and some commenters noted that policies and procedures alone would be sufficient to address hedging activity, wherever conducted within the organization.1250  Two commenters indicated that making the documentation requirement narrower is necessary to avoid impacts or delays in daily trading operations that could lead to a banking entity being exposed to greater risks.1251  A number of commenters stated that any enhanced documentation requirement would be burdensome and costly, and would impede rapid and effective risk mitigation, whether done at a trading desk or elsewhere in the banking entity.1252  
At least one commenter also argued that a banking entity should be permitted to consolidate some or all of its hedging activity into a trading desk that is not responsible for the underlying positions without triggering a requirement that all hedges undertaken by a trading desk be documented solely because the hedges are not undertaken by the trading desk that originated the underlying position.1253  
The final rule substantially retains the proposed requirement for enhanced documentation for hedging activity conducted under the hedging exemption if the hedging is not conducted by the specific trading desk establishing or responsible for the underlying positions, contracts, or other holdings, the risks of which the hedging activity is designed to reduce.  The final rule clarifies that a banking entity must prepare enhanced documentation if a trading desk establishes a hedging position and is not the trading desk that established the underlying positions, contracts, or other holdings.  The final rule also requires enhanced documentation for hedges established to hedge aggregated positions across two or more desks.  This change in the final rule clarifies that the level of the organization at which the trading desk exists is important for determining whether the trading desk established or is responsible for the underlying positions, contracts, or other holdings.  The final rule recognizes that a trading desk may be responsible for hedging aggregated positions of that desk and other desks, business units, or affiliates.  In that case, the trading desk putting on the hedge is at least one step removed from some of the positions being hedged.  Accordingly, the final rule provides that the documentation requirements in § __.5 apply if a trading desk is hedging aggregated positions that include positions from more than one trading desk.  
The final rule adds to the proposal by requiring enhanced documentation for hedges established by the specific trading desk establishing or directly responsible for the underlying positions, contracts, or other holdings, the risks of which the purchases or sales are designed to reduce, if the hedge is effected through a financial instrument, technique, or strategy that is not specifically identified in the trading desk’s written policies and procedures as a product, instrument, exposure, technique, or strategy that the trading desk may use for hedging.1254  The Agencies note that this documentation requirement does not apply to hedging activity conducted by a trading desk in connection with the market making-related activities of that desk or by a trading desk that conducts hedging activities related to the other permissible trading activities of that desk so long as the hedging activity is conducted in accordance with the compliance program for that trading desk. 
The Agencies continue to believe that, for the reasons stated in the proposal, it is appropriate to retain documentation of hedging transactions conducted by those other than the traders responsible for the underlying position in order to permit evaluation of the activity.  In order to reduce the burden of the documentation requirement while still giving effect to the rule’s purpose, the final rule requires limited documentation for hedging activity that is subject to a documentation requirement, consisting of: (1) the specific, identifiable risk(s) of the identified positions, contracts, or other holdings that the purchase or sale is designed to reduce; (2) the specific risk-mitigating strategy that the purchase or sale is designed to fulfill; and (3) the trading desk or other business unit that is establishing and responsible for the hedge transaction.  As in the proposal, this documentation must be established contemporaneously with the hedging transaction.  Documentation would be contemporaneous if it is completed reasonably promptly after a trade is executed.  The banking entity is required to retain records for no less than 5 years (or such longer period as may be required under other law) in a form that allows the banking entity to promptly produce such records to the Agency on request.1255  While the Agencies recognize this documentation requirement may result in certain costs, the Agencies believe this requirement is necessary to prevent evasion of the statute and final rule.   
            5. Section __.6(a)-(b):  Permitted Trading in Certain Government and Municipal Obligations	
Section __.6 of the proposed rule permitted a banking entity to engage in trading activities that were authorized by section 13(d)(1) of the BHC Act,1256 including trading in certain government obligations, trading on behalf of customers, trading by insurance companies, and trading outside of the United States by certain foreign banking entities.1257  Section __.6 of the final rule generally incorporates these same statutory exemptions.  However, the final rule has been modified in some ways in response to comments received on the proposal.
                a. Permitted Trading in U.S. Government Obligations
Section 13(d)(1)(A) permits trading in various U.S. government, U.S. agency and municipal securities.1258  Section __.6(a) of the proposed rule, which implemented section 13(d)(1)(A) of the BHC Act, permitted the purchase or sale of a financial instrument that is an obligation of the United States or any agency thereof or an obligation, participation, or other instrument of or issued by the Government National Mortgage Association, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, a Federal Home Loan Bank, the Federal Agricultural Mortgage Corporation or a Farm Credit System institution chartered under and subject to the provisions of the Farm Credit Act of 1971 (12 U.S.C. 2001 et seq.).1259  The proposal did not contain an exemption for trading in derivatives referencing exempt U.S. government and agency securities, but requested comment on whether the final rule should contain an exemption for proprietary trading in options or other derivatives referencing an exempt government obligation.1260  
Commenters were generally supportive of the manner in which the proposal implemented the exemption for permitted trading in U.S. government and U.S. agency obligations.1261  Many commenters argued that the exemption for permissible proprietary trading in government obligations should be expanded, however, to include trading in derivatives on government obligations.1262  These commenters asserted that failure to provide an exemption would adversely impact liquidity in the underlying government obligations themselves and increase borrowing costs to governments.1263  Several commenters asserted that U.S. government and agency obligations and derivatives on those instruments are substitutes and pose the same investment risks and opportunities.1264  According to some commenters, the significant connections between these markets and the interchangeable nature of these instruments significantly contribute to price discovery, in particular, in the cash market for U.S. Treasury obligations.1265  Commenters also argued that trading in Treasury futures and options improves liquidity in Treasury securities markets by providing an outlet to relieve any supply and demand imbalances in spot obligations. Many commenters argued that the authority to engage in trading in derivatives on U.S. government, agency, and municipal obligations is inherent in the statutory exceptions granted by section 13(d)(1)(A) to trade in the underlying obligation.1266  To the extent there is any doubt about the scope of those exemptions, commenters urged the Agencies to use the exemptive authority under section 13(d)(1)(J) if necessary to permit proprietary trading in derivatives on government obligations.1267  Two commenters opposed providing an exemption for proprietary trading in derivatives on exempt government obligations.1268
The final rule has not been modified to permit a banking entity to engage in proprietary trading of derivatives on U.S. government and agency obligations.
The Agencies note that the cash market for exempt government obligations is already one of the most liquid markets in the world, and the final rule will permit banking entities to participate fully in these cash markets.  In addition, the final rule permits banking entities to make a market in U.S. government securities and in derivatives on those securities.  Moreover, the final rule allows banking entities to continue to use U.S. government obligations and derivatives on those obligations in risk-mitigating hedging activities permitted by the rule.  Further, proprietary trading in derivatives on such obligations will continue by entities other than banking entities.
Proprietary trading of derivatives on U.S. government obligations is not necessary to promote and protect the safety and soundness of a banking entity or the financial stability of the United States.  Commenters offered no compelling reasons why derivatives on exempt government obligations pose little or no risk to the financial system as compared to derivatives on other financial products for which proprietary trading is generally prohibited and did not indicate how proprietary trading in derivatives of U.S. government and agency obligations by banking entities would promote the safety and soundness of those entities or the financial stability of the United States.  For these reasons, the Agencies have not determined to provide an exemption for proprietary trading in derivatives on exempt government obligations.
The Agencies believe banking entities will continue to provide significant support and liquidity to the U.S. government and agency security markets through permitted trading in the cash exempt government obligations markets, making markets in government obligation derivatives and through derivatives trading for hedging purposes.  The final rule adopts the same approach as the proposed rule for the exemption for permitted trading in U.S. government and U.S. agency obligations.  In response to commenters, the Agencies are clarifying how banking entities would be permitted to use Treasury derivatives on Treasury securities when relying on the exemptions for market-making related activities and risk-mitigating hedging activities.  The Agencies agree with commenters that some Treasury derivatives are close economic substitutes for Treasury securities and provide many of the same economic exposures.1269  The Agencies also understand that the markets for Treasury securities and Treasury futures are fully integrated, and that trading in these derivative instruments is essential to ensuring the continued smooth functioning of market-making related activities in Treasury securities.  Treasury derivatives are frequently used by market makers to hedge their market-making related positions across many different types of fixed-income securities.  Under the final rule, market makers will generally be able to continue their practice of using Treasury futures to hedge their activities as block positioners off exchanges.  Additionally, when engaging in permitted market-making related or risk-mitigating hedging activities in accordance with the requirements in §§___.4(b) or ___.(5), the final rule permits banking entities to acquire a short or long position in Treasury futures through manual trading or automated processes.  For example, a banking entity would be permitted to use Treasury futures to hedge the duration risk (i.e., the measure of a bond’s price sensitivity to interest rates movements) associated with the banking entity’s market-making in Treasury securities or other fixed-income products, provided that the banking entity complies with the market-making requirements in § __.4(b).  In their market making, banking entities also frequently trade Treasury futures (and acquire a corresponding long or short position) in reasonable anticipation of the near-term demands of their clients, customers, and counterparties.  For example, banking entities may acquire a long or short position in Treasury futures to hedge anticipated market risk when they reasonably expect clients, customers, or counterparties will seek to establish long or short positions in on- or off-the-run Treasury securities.  Similarly, banking entities could acquire a long or short position in the “Treasury basis” to hedge the anticipated basis risk associated with making markets for clients, customers, or counterparties that are reasonably expected to engage in basis trading of the price spread between Treasury futures and Treasury securities.  A banking entity can also use Treasury futures (or other derivatives on exempt government obligations) to hedge other risks such as the aggregated interest rate risk for specifically identified loans as well as other financial instruments such as asset-backed securities, corporate bonds, and interest rate swaps.  Therefore, depending on the relevant facts and circumstances, banking entities would be permitted to acquire a very large long or short position in Treasury derivatives provided that they comply with the requirements in §§___.4(b) or ___.(5).  The Agencies also understand that banking entities that have been designated as “primary dealers” by the Federal Reserve Bank of New York are required to underwrite issuances of Treasury securities.  This necessitates the banking entities to frequently establish very large short positions in Treasury futures to order to hedge the duration risk associated with potentially owning a large volume of Treasury securities. As described below,1270 the Agencies note that, with respect to a banking entity that acts as a primary dealer for Treasury securities, the U.S. government will be considered a client, customer, or counterparty of the banking entity for purposes of the market-making exemption.1271  We believe this interpretation appropriately captures the unique relationship between a primary dealer and the government.  Moreover, this interpretation clarifies that a banking entity may rely on the market-making exemption for its activities as primary dealer to the extent those activities are outside the scope of the underwriting exemption.1272  
The final rule also includes an exemption for obligations of or guaranteed by the United States or an agency of the United States.  An obligation guaranteed by the U.S. or an agency of the U.S. is, in effect, an obligation of the U.S. or that agency.
The final rule also includes an exemption for an obligation of the FDIC, or any entity formed by or on behalf of the FDIC for the purpose of facilitating the disposal of assets acquired or held by the FDIC in its corporate capacity or as conservator or receiver under the Federal Deposit Insurance Act (“FDI Act”) or Title II of the Dodd-Frank Act.1273  These FDIC receivership and conservatorship operations are authorized under the FDI Act and Title II of the Dodd-Frank Act and are designed to lower the FDIC’s resolution costs.  The Agencies believe that an exemption for these types of obligations would promote and protect the safety and soundness of banking entities and the financial stability of the United States because they facilitate the FDIC’s ability to conduct receivership and conservatorship operations in an orderly manner, thereby limiting risks to the financial system generally that might otherwise occur if the FDIC was restricted in its ability to conduct these operations.  
                a. Permitted Trading in Foreign Government Obligations
	The proposed rule did not contain an exemption for trading in obligations of foreign sovereign entities.  As part of the proposal, however, the Agencies specifically requested comment on whether proprietary trading in the obligations of foreign governments would promote and protect the safety and soundness of banking entities and the financial stability of the United States under section 13(d)(1)(J) of the BHC Act.1274  
	The treatment of proprietary trading in foreign sovereign obligations prompted a significant number of comments.  Many commenters, including foreign governments, foreign and domestic banking entities, and various trade groups, argued that the final rule should permit trading in foreign sovereign debt, including obligations issued by political subdivisions of foreign governments.1275  Representatives from foreign governments such as Canada, Germany, Luxembourg, Japan, Australia, and Mexico specifically requested an exemption for trading in obligations of their governments and argued that an exemption was necessary and appropriate to maintain and promote financial stability in their markets.1276  Some commenters also requested an exemption for trading in obligations of multinational central banks, such as Eurobonds issued or guaranteed by the European Central Bank.1277
	Many commenters argued that the same rationale for the statutory exemption for proprietary trading in U.S. government obligations supported exempting proprietary trading in foreign sovereign debt and related obligations.1278  Commenters contended that lack of an express exemption for trading in foreign sovereign obligations could critically impact the functioning of money market operations of foreign central banks and limit the ability of foreign sovereign governments to conduct monetary policy or finance their operations.1279  These commenters also contended that an exemption for proprietary trading in foreign sovereign debt would promote and protect the safety and soundness and the financial stability of the United States by avoiding the possible negative effects of a contraction of government bond market liquidity.1280  
	Commenters also contended that in some foreign markets, local regulations or market practice require U.S. banking entities operating in those jurisdictions to hold, trade or support government issuance of local sovereign securities.  They also indicated that these instruments are traded in the United States or on U.S. markets.1281  In addition, a number of commenters contended that U.S. and foreign banking entities often perform functions for foreign governments similar to those provided in the United States by U.S. primary dealers and alleged that restricting these trading activities would have a significant negative impact on the ability of foreign governments to implement their monetary policy and on liquidity for such securities in many foreign markets.1282  A few commenters further argued that banking entities use foreign sovereign debt, particularly debt of their home country and of the country in which they are operating, to manage their risk by posting sovereign securities as collateral in foreign jurisdictions, to manage international rate and foreign exchange risk (particularly in local operations), and for liquidity and asset-liability management purposes in different countries.1283  Similarly, commenters expressed concern that the lack of an exemption for trading in foreign government obligations could adversely interact with other banking regulations, such as liquidity requirements under the Basel III capital rules that encourage financial institutions to hold large concentrations of sovereign bonds to match foreign currency denominated obligations.1284  Commenters also expressed particular concern that the limitations and obligations of section 13 of the BHC Act would likely be problematic and unduly burdensome if banking entities were able to trade in foreign sovereign obligations only under the market making or other proposed exemptions from the proprietary trading prohibition.1285  One commenter expressed the view that lack of an exemption for proprietary trading in foreign government obligations together with the proposed exemption for trading that occurs solely outside the U.S. may cause foreign banks to close their U.S. branches to avoid being subject to section 13 of the BHC Act and any final rule thereunder.1286
	According to some commenters, providing an exemption only for proprietary trading in U.S. government obligations, without a similar exemption for foreign government obligations, would be discriminatory and inconsistent with longstanding principles of national treatment and with U.S. treaty obligations, such as obligations under the World Trade Organization framework or bilateral trade agreements.1287  In addition, several commenters argued that not exempting proprietary trading of foreign sovereign debt may encourage foreign regulators to enact similar regulations to the detriment of U.S. financial institutions operating abroad.1288  However, another commenter disagreed that the failure to exempt trading in foreign government obligations would violate trade agreements or that the proposal discriminated in any way against foreign banking entities’ ability to compete with U.S. banking entities in the U.S.1289
	Based on these concerns, some commenters suggested that the Agencies exempt proprietary trading by foreign banking entities in obligations of their home or host country.1290  Other commenters suggested allowing trading in foreign government obligations that meet some condition on quality (e.g., OECD-member country obligations, government bonds eligible as collateral for Federal Reserve advances, sovereign bonds issued by G-20 countries, or other highly liquid or rated instruments).1291  One commenter indicated that in their view, provided appropriate risk-management procedures are followed, investing in non-U.S. government securities is as low risk as investing in U.S. government securities despite current price volatility in certain types of sovereign debt.1292  Some commenters also suggested the final rule give deference to home country regulation and permit foreign banking entities to engage in proprietary trading in any government obligation to the extent that such trading is permitted by the entity’s primary regulator.1293
	By contrast, other commenters argued that proprietary trading in foreign sovereign obligations represents a risky activity and that there is no effective way to draw the line between safe and unsafe foreign debt.1294  Two of these commenters pointed to several publicly reported instances where proprietary trading in foreign sovereign obligations resulted in significant losses to certain firms.  These commenters argued that restricting proprietary trading in foreign sovereign debt would not cause reduced liquidity in government bond markets since banking entities would still be permitted to make a market in and underwrite foreign government obligations.1295  A few commenters suggested that, if the final rule exempted proprietary trading in foreign sovereign debt, foreign governments should commit to pay for any damage to the U.S. financial system related to proprietary trading in their obligations pursuant to such exemption.1296
	The Agencies carefully considered all the comments related to proprietary trading in foreign sovereign debt in light of the language, purpose and standards for exempting activity contained in section 13 of the BHC Act.  Under section 13(d)(1)(J), the Agencies may grant an exemption from the prohibitions of the section for any activity that the Agencies determine would promote and protect the safety and soundness of the banking entity and the financial stability of the United States.  
	The Agencies note as an initial matter that section 13 permits banking entities – both inside the United States and outside the United States – to make markets in and to underwrite all types of securities, including all types of foreign sovereign debt.  The final rule implements the statutory market-making and underwriting exemptions, and thus, the key role of banking entities in facilitating trading and liquidity in foreign government debt through market-making and underwriting is maintained.  This includes underwriting and marketmaking as a primary dealer in foreign sovereign obligations.  Banking entities may also hold foreign sovereign debt in their long-term investment book.  In addition, the final rule does not prevent foreign banking entities from engaging in proprietary trading outside of the United States in any type of sovereign debt.1297  Moreover, the Agencies continue to believe that positions, including positions in foreign government obligations, acquired or taken for the bona fide purpose of liquidity management and in accordance with a documented liquidity management plan that is consistent with the relevant Agency’s supervisory requirements, guidance and expectations regarding liquidity management are not covered by the prohibitions in section 13.1298  The final rule continues to incorporate this view.1299  
	The issue raised by commenters, therefore, is the extent to which proprietary trading in foreign sovereign obligations by U.S. banking entities anywhere in the world and by foreign banking entities in the United States is consistent with promoting and protecting the safety and soundness of the banking entity and the financial stability of the United States.  Taking into account the information provided by commenters, the Agencies’ understanding of market operations, and the purpose and language of section 13, the Agencies have determined to grant a limited exemption to the prohibition on proprietary trading for trading in foreign sovereign obligations under certain circumstances.   
This exemption, which is contained in § __.6(b) of the final rule, permits the U.S. operations of foreign banking entities to engage in proprietary trading in the United States in the foreign sovereign debt of the foreign sovereign under whose laws the banking entity – or the banking entity that controls it – is organized (hereinafter, the “home country”), and any multinational central bank of which the foreign sovereign is a member so long as the purchase or sale as principal is not made by an insured depository institution.1300  Similar to the exemption for proprietary trading in U.S. government obligations, the permitted trading activity in the U.S. by the eligible U.S. operations of a foreign banking entity would extend to obligations of politic