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Loan Level Hedging Programs Under the Volcker Rule

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Regulatory Alert The Volcker Rule: Loan Level Hedging Under the Market Making Exemption Many financial institutions have questioned whether and how the Volcker Rule's proprietary trading ban will impact their loan level hedging programs. The Volcker Rule's proprietary trading ban is essentially a prohibition on short-term speculative trading and generally prohibits the use of derivatives principally for the purpose of: (1) short-term resale; (2) benefitting from short-term price movements; (3) realizing short-term arbitrage profits; or (4) hedging positions relating to any of the above. Certain proprietary trading activity is expressly permitted if the financial institution conforms to one of the Volcker Rule's exceptions – namely market making, risk- mitigating hedging and underwriting – and implements a compliance program. Regulators have indicated that a financial institution desiring to conform its loan level hedging program to a permitted form of proprietary trading should pursue the market making exemption for such activities. This guide briefly summarizes the market making exemption and the necessary components of the accompanying compliance program. The Market Making Exemption The Volcker Rule provides an exemption from the proprietary trading ban for purchases and sales in connection with market making-related activities. Broadly speaking, in order to rely on this exemption, the market-making activities must be designed to not exceed the reasonably expected near-term demands (RENTD) of clients, customers and counterparties. RENTD is an estimate of future customer demand that financial institutions must consider when setting risk and position limits in relation to market making activity. In addition, the financial institution must: (1) routinely stand ready to buy and sell financial instruments with the market for its own account; (2) adopt certain policies, including a description of the financial instruments in which the trading desk makes a market, activities taken by the trading desk to hedge its risk, limits on inventory and financial exposure, and internal controls monitoring the market making activity; and (3) devise and implement a compliance program in conformance with the Volcker Rule. The compensation arrangements of persons performing market-related activities must also be reviewed to ensure they are not designed to reward or incentivize proprietary risk taking.

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