that apply if a trader seeks to conduct hedging activities beyond the
limits, position types, strategies, or techniques authorized for the
trader's activities.\1237\
---------------------------------------------------------------------------

    \1237\ A banking entity must satisfy the enhanced documentation
requirements of Sec.  ----.5(c) if it engages in hedging activity
utilizing positions, contracts, or holdings that were not identified
in its written policies and procedures.

---------------------------------------------------------------------------

    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.\1238\ 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.\1239\ 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.'' \1240\
---------------------------------------------------------------------------

    \1238\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Barclays;
ICI (Feb. 2012); Morgan Stanley.
    \1239\ See Barclays.
    \1240\ Final rule Sec.  ----.5(b)(2)(iv)(B). The Agencies
believe this provision addresses some commenters' concern that the
ongoing review, monitoring, and management requirement would limit
hedging of aggregated positions, and that such ongoing review of
individual hedge transactions with a variety of underlying risks
would be impossible. See SIFMA (Prop. Trading) (Feb. 2012);
Barclays; ICI (Feb. 2012); Morgan Stanley.
---------------------------------------------------------------------------

    A number of other commenters argued that a legitimate risk-reducing
hedge may introduce new risks at inception.\1241\ 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.\1242\ 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.\1243\ 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.\1244\ Another commenter stated that this
requirement could have a chilling effect on risk managers' willingness
to engage in otherwise permitted hedging activity.\1245\
---------------------------------------------------------------------------

    \1241\ See ABA (Keating); BoA; Barclays; Credit Suisse (Seidel);
Goldman (Prop. Trading); SIFMA et al. (Prop. Trading) (Feb. 2012);
See also AFR et al. (Feb. 2012).
    \1242\ See Credit Suisse (Seidel); Goldman (Prop. Trading);
SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1243\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Barclays.
    \1244\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1245\ See BoA.
---------------------------------------------------------------------------

    Other commenters stated that a position that does not fully offset
the risk of an underlying position is not in fact a hedge.\1246\ 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.\1247\
---------------------------------------------------------------------------

    \1246\ See Sens. Merkley & Levin (Feb. 2012); Public Citizen;
AFR (Nov. 2012).
    \1247\ See Better Markets (Feb. 2012); AFR et al. (Feb. 2012).
---------------------------------------------------------------------------

    The Agencies recognize that prudent risk-reducing hedging
activities by banking entities are important to the efficiency of the
financial system.\1248\ 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.\1249\
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.
---------------------------------------------------------------------------

    \1248\ See FSOC study (stating that ``[p]rudent risk management
is at the core of both institution-specific safety and soundness, as
well as macroprudential and financial stability'').
    \1249\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------

    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.\1250\ As noted in the proposal, however, the Agencies
recognize that exposure to new risks may result from legitimate hedging
transactions; \1251\ this provision only prohibits the introduction of
additional significant exposures through the hedging transaction unless
those additional exposures are contemporaneously hedged.
---------------------------------------------------------------------------

    \1250\ Some commenters stated that it is not always possible to
hedge a new risk exposure arising from a hedge in a cost-effective
manner, and requiring contemporaneous hedges would raise transaction
costs and the potential for hedges to become uneconomical. See SIFMA
et al. (Prop. Trading) (Feb. 2012); Barclays. As noted in the
proposal, the Agencies believe that requiring a contemporaneous
hedge of any significant new risk that arises at the inception of a
hedge is appropriate because a transaction that creates significant
new risk exposure that is not itself hedged at the same time would
appear to be indicative of prohibited proprietary trading. See Joint
Proposal, 76 FR 68,876. Thus, the Agencies believe this requirement
is necessary to prevent evasion of the general prohibition on
proprietary trading. In response to commenters' concerns about
transaction costs and uneconomical hedging, the Agencies note that
this provision only requires additional hedging of ``significant''
new or additional risk and does not apply to any risk exposure
arising from a hedge.
    \1251\ See Joint Proposal, 76 FR 68,876.
---------------------------------------------------------------------------

    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.\1252\ 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 exemption \1253\ with concerns that allowing banking
entities to rely on the cheapest satisfactory hedge will lead to
additional hedging transactions.\1254\ 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.\1255\
---------------------------------------------------------------------------

    \1252\ See final rule Sec.  ----.5(b)(2)(ii).
    \1253\ See SIFMA (Prop. Trading) (Feb. 2012); Credit Suisse
(Seidel); Barclays; Goldman (Prop. Trading); BoA.
    \1254\ See Occupy.
    \1255\ See Barclays.
---------------------------------------------------------------------------

    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 . . . .'' \1256\
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.\1257\ This approach is consistent with prudent
risk-management and safe and sound banking practice.\1258\
---------------------------------------------------------------------------

    \1256\ 12 U.S.C. 1851(d)(1)(C).
    \1257\ See Joint Proposal, 76 FR 68,875.
    \1258\ See, e.g., Australian Bankers' Ass'n. (Feb. 2012); BoA;
Barclays; Credit Suisse (Seidel); Goldman (Prop. Trading); HSBC; ICI
(Feb. 2012); Japanese Bankers Ass'n.; JPMC; Morgan Stanley; Wells
Fargo (Prop. Trading); Rep. Bachus et al.; RBC; SIFMA (Prop.
Trading) (Feb. 2012).
---------------------------------------------------------------------------

    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.\1259\
---------------------------------------------------------------------------

    \1259\ See, e.g. ABA (Keating); Ass'n. of Institutional
Investors (Sept. 2012); BoA; See also Barclays (expressing concern
that the proposed rule could result in regulatory review of
individual hedging trades for compliance on a post hoc basis); HSBC;
ISDA (Apr. 2012); ICI (Feb. 2012); PNC; MetLife; RBC; SIFMA (Prop.
Trading) (Feb. 2012).
---------------------------------------------------------------------------

    By contrast, other commenters argued that portfolio-based hedging
could be used to mask prohibited proprietary trading.\1260\ One
commenter contended that the statute provides no basis for portfolio
hedging, and another commenter similarly suggested that portfolio
hedging should be prohibited.\1261\ 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.'' \1262\ 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.\1263\ 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.\1264\
---------------------------------------------------------------------------

    \1260\ See, e.g., AFR et al. (Feb. 2012); Sens. Merkley & Levin
(Feb. 2012); Occupy; Public Citizen; Johnson & Prof. Stiglitz.
    \1261\ See Sens. Merkley & Levin (Feb. 2012) (commenting that
the use of the term ``aggregate'' positions was intended to note
that firms do not have to hedge on a trade-by-trade basis but could
not hedge on a portfolio basis); Johnson & Prof. Stiglitz.
    \1262\ See AFR et al. (Feb. 2012) (citing 156 Cong. Rec. S5898
(daily ed. July 15, 2010) (statement of Sen. Merkley)).
    \1263\ See, e.g., Occupy; Public Citizen.
    \1264\ See Public Citizen; Occupy; AFR et al. (Feb. 2012).
---------------------------------------------------------------------------

    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.\1265\ Further, the Agencies believe the adopted
exemption allows banking entities to engage in hedging of aggregated
positions \1266\ while helping to ensure that such hedging activities
are truly risk-mitigating.\1267\
---------------------------------------------------------------------------

    \1265\ See AFR et al. (Feb. 2012) (citing 156 Cong. Rec. S5898
(daily ed. July 15, 2010) (statement of Sen. Merkley)).
    \1266\ See MetLife; SIFMA et al. (Prop. Trading) (Feb. 2012);
Morgan Stanley; Barclays; Goldman (Prop. Trading); BoA; ABA
(Keating); HSBC; Fixed Income Forum/Credit Roundtable; ICI (Feb.
2012); ISDA (Feb. 2012).
    \1267\ The Agencies believe certain limits suggested by
commenters, such as the formation of central ``risk management''
groups to monitor hedges of aggregated positions, are unnecessary
given the aforementioned limits in the final rule. See Occupy;
Public Citizen.
---------------------------------------------------------------------------

    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 . . . .'' \1268\ 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.
---------------------------------------------------------------------------

    \1268\ See 12 U.S.C. 1851(d)(1)(C).
---------------------------------------------------------------------------

    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.\1269\ 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.
---------------------------------------------------------------------------

    \1269\ The Agencies believe that it would be inconsistent with
Congressional intent to permit some or all of these activities under
the hedging exemption, regardless of whether certain metrics could
be useful for monitoring such activity. See JPMC.
---------------------------------------------------------------------------

    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 Sec.
----.5(b)(2)(ii) and, where applicable, Sec.  ----.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.\1270\ 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.\1271\
---------------------------------------------------------------------------

    \1270\ See proposed rule Sec.  ----.5(b)(2)(ii) (requiring that
the hedging transaction ``hedges or otherwise mitigates one or more
specific risks . . . arising in connection with and related to
individual or aggregated positions, contracts, or other holdings of
[the] banking entity''). The proposal noted that this requirement
would include, for example, dynamic hedging. See Joint Proposal, 76
FR 68,875.
    \1271\ The proposal noted that this corresponding modification
to the hedge should also be reasonably correlated to the material
changes in risk that are intended to be hedged or otherwise
mitigated, as required by Sec.  ----.5(b)(2)(iii) of the proposed
rule.
---------------------------------------------------------------------------

    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.\1272\
---------------------------------------------------------------------------

    \1272\ See AFR et al. (Feb. 2012); Public Citizen; See also
Better Markets (Feb. 2012), Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

    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,\1273\ 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.\1274\
---------------------------------------------------------------------------

    \1273\ See Japanese Bankers Ass'n.
    \1274\ See, e.g., BoA; Barclays; ISDA (Apr. 2012); PNC; PNC et
al.; SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------

    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.\1275\
---------------------------------------------------------------------------

    \1275\ See, e.g., Occupy; Public Citizen; AFR et. al. (Feb.
2012); AFR (June 2013); Better Markets (Feb. 2012); Sens. Merkley &
Levin (Feb. 2012).
---------------------------------------------------------------------------

    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.\1276\
Some commenters represented that the proposed provision would cause
certain administrative burdens \1277\ or may result in a reduction in
market-making activities in certain asset classes.\1278\ 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.\1279\ Some commenters argued the focus of the hedging
exemption should be on risk reduction and not on reasonable
correlation.\1280\ 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.\1281\
---------------------------------------------------------------------------

    \1276\ See BoA; Barclays; Comm. on Capital Markets Regulation;
Credit Suisse (Seidel); FTN; Goldman (Prop. Trading); ICI (Feb.
2012); Japanese Bankers Ass'n.; JPMC; Morgan Stanley; SIFMA et al.
(Prop. Trading) (Feb. 2012); STANY; See also Chamber (Feb. 2012).
    \1277\ See Japanese Bankers Ass'n.; Goldman (Prop. Trading);
BoA.
    \1278\ See BoA; SIFMA (Asset Mgmt.) (Feb. 2012). As discussed
above, market-maker hedging at the trading desk level is no longer
subject to the hedging exemption and is instead subject to the
requirements of the market-making exemption, which is designed to
permit banking entities to continue providing legitimate market-
making services, including managing the risk of market-making
activity. See also supra Part IV.A.3.c.4. of this SUPPLEMENTARY
INFORMATION.
    \1279\ See Barclays; Goldman (Prop. Trading); Chamber (Feb.
2012); SIFMA et al. (Prop. Trading) (Feb. 2012); See also FTN; BoA.
    \1280\ See, e.g., FTN; Goldman (Prop. Trading); ISDA (Apr.
2012); See also Sens. Merkley & Levin (Feb. 2012); Occupy.
    \1281\ See Goldman (Prop. Trading). 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. See infra Part IV.C.3.; final rule Appendix A.
The Agencies do not intend to use quantitative measurements as a
dispositive tool for differentiating between permitted hedging
activities and prohibited proprietary trading.
---------------------------------------------------------------------------

    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.\1282\ 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.\1283\ 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.\1284\ 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,\1285\ and require an after-the-fact
analysis.\1286\
---------------------------------------------------------------------------

    \1282\ Some commenters stated that the hedging exemption should
focus on risk reduction, not reasonable correlation. See, e.g., FTN;
Goldman (Prop. Trading); ISDA (Apr. 2012); Sens. Merkley & Levin
(Feb. 2012); Occupy. One of these commenters noted that demonstrated
risk reduction should be a key requirement. See Sens. Merkley &
Levin (Feb. 2012).
    \1283\ See FTN; Goldman (Prop. Trading); ISDA (Apr. 2012); See
also Sens. Merkley & Levin (Feb. 2012); Occupy.
    \1284\ See final rule Sec.  ----.5(b)(1)(iii).
    \1285\ Some commenters expressed concern that the proposed
``reasonable correlation'' requirement might impede truly risk-
reducing activity. See, e.g., BoA; Barclays; Comm. on Capital
Markets Regulation; Credit Suisse (Seidel); FTN; Goldman (Prop.
Trading); ICI (Feb. 2012); ISDA (Apr. 2012); Japanese Bankers
Ass'n.; JPMC; Morgan Stanley; PNC; PNC et al.; SIFMA et al. (Prop.
Trading) (Feb. 2012); STANY. Some of these commenters stated that
the proposed requirement would cause administrative burdens. See
Japanese Bankers Ass'n.; Goldman (Prop. Trading); BoA.
    \1286\ See Barclays; Goldman (Prop. Trading); Chamber (Feb.
2012); SIFMA et al. (Prop. Trading) (Feb. 2012; See also FTN.
---------------------------------------------------------------------------

    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 Sec.  ----.5.\1287\
---------------------------------------------------------------------------

    \1287\ By contrast, the proposed requirement did not specify
that the hedging activity reduce risk ``at the inception of the
hedge.'' See proposed rule Sec.  ----.5(b)(2)(ii).
---------------------------------------------------------------------------

    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.\1288\ 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 conditions \1289\ while also seeking to prohibit the
banking entity from taking large proprietary positions through action
or inaction related to an otherwise permissible hedge.\1290\
---------------------------------------------------------------------------

    \1288\ Some commenters noted that hedging activities must
address constantly changing positions and market conditions and
expressed concern about requiring a banking entity to identify the
particular risk being hedged. See Japanese Bankers Ass'n.; Barclays.
    \1289\ A few commenters expressed concern that the proposed
``reasonable correlation'' requirement would render hedges
impermissible if not reasonably correlated to the relevant risk(s)
based on a post hoc analysis. See, e.g., Barclays; Goldman (Prop.
Trading); Chamber (Feb. 2012); SIFMA et al. (Prop. Trading) (Feb.
2012).
    \1290\ Some commenters questioned the risk-mitigating nature of
a hedge if, at inception, it contained risks that must be
dynamically managed throughout the life of the hedge. See, e.g., AFR
et al. (Feb. 2012); Public Citizen.
---------------------------------------------------------------------------

    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.\1291\
---------------------------------------------------------------------------

    \1291\ See Joint Proposal, 76 FR 68,875.
---------------------------------------------------------------------------

    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.\1292\ 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.\1293\
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
executions \1294\ and limit dynamic hedging activities that are
important to sound risk management.\1295\ 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.''\1296\
---------------------------------------------------------------------------

    \1292\ See, e.g., Barclays; SIFMA et al. (Prop. Trading);
Japanese Bankers Ass'n.; Credit Suisse (Seidel); BoA; PNC et al.;
ISDA (Feb. 2012).
    \1293\ See BoA; Credit Suisse (Seidel); ISDA (Feb. 2012); JPMC;
Morgan Stanley; PNC et al.; SIFMA et al. (Prop. Trading) (Feb.
2012).
    \1294\ See Credit Suisse (Seidel); BoA.
    \1295\ See PNC et al.
    \1296\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC;
Goldman (Prop. Trading); BoA; Comm. on Capital Market Regulation. As
discussed above, hedging activity relying on this exemption 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.
---------------------------------------------------------------------------

    Some commenters expressed concern about the proposed criterion that
the hedging activity not involve the potential for speculative
profit.\1297\ 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).\1298\ 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.\1299\
---------------------------------------------------------------------------

    \1297\ See ABA (Keating); CH/ABASA; See also Credit Suisse
(Seidel); PNC; PNC et al.; SIFMA et al. (Prop. Trading) (Feb. 2012).
One commenter argued that anticipatory hedging should not be
permitted because it represents illegal front running. See Occupy.
The Agencies note that not all anticipatory hedging would constitute
illegal front running. Any activity that is illegal under another
provision of law, such as front running under section 10(b) of the
Exchange Act, remains illegal; and section 13 of the BHC Act and any
implementing rules thereunder do not represent a grant of authority
to engage in any such activity. See 15 U.S.C. 78j.
    \1298\ As discussed above, the final hedging exemption replaces
the ``reasonable correlation'' concept with the requirement that
hedging activity ``demonstrably reduce or otherwise significantly
mitigate'' specific, identifiable risks.
    \1299\ See AFR et al. (Feb. 2012); See also Part IV.C.3.d.,
infra.
---------------------------------------------------------------------------

    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.\1300\ 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.\1301\ 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 Sec.  ----.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.
---------------------------------------------------------------------------

    \1300\ This requirement modifies proposed rule Sec. Sec.  --
--.5(b)(2)(ii) and (iii). As discussed above, the addition of
``demonstrably reduces or significantly mitigates'' language
replaces the proposed ``reasonable correlation'' requirement.
    \1301\ The proposed rule contained a similar provision, except
that the proposed provision also required that the continuing review
maintain a reasonable level of correlation between the hedge
transaction and the risk being hedged. See proposed rule Sec.  --
--.5(b)(2)(v). As discussed above, the proposed ``reasonable
correlation'' requirement was removed from that provision and
instead a requirement has been added to the compliance program
provision that correlation analysis be undertaken when analyzing
hedging positions, techniques, and strategies before they are
implemented.
---------------------------------------------------------------------------

    As noted above, one commenter suggested the Agencies adopt a metric
to monitor the profitability of a banking entity's hedging
activity.\1302\ 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.
---------------------------------------------------------------------------

    \1302\ See AFR et al. (Feb. 2012).
---------------------------------------------------------------------------

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.\1303\ 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.\1304\
---------------------------------------------------------------------------

    \1303\ See proposed rule Sec.  ----.5(b)(2)(vi).
    \1304\ See Joint Proposal, 76 FR 68,868.
---------------------------------------------------------------------------

    Commenters generally supported this requirement and indicated that
its inclusion was very important and valuable.\1305\ 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.\1306\ In contrast, other commenters argued that
the compensation requirement should restrict only compensation
arrangements that incentivize employees to engage in prohibited
proprietary risk-taking.\1307\
---------------------------------------------------------------------------

    \1305\ See, e.g., AFR et al. (Feb. 2012); Sens. Merkley & Levin
(Feb. 2012); Public Citizen.
    \1306\ See AFR et al. (Feb. 2012); AFR (June 2013).
    \1307\ See Morgan Stanley.
---------------------------------------------------------------------------

    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.\1308\
---------------------------------------------------------------------------

    \1308\ One commenter stated that the compensation requirement
should restrict only compensation arrangements that incentivize
employees to engage in prohibited proprietary risk-taking, rather
than apply to hedging activities. See Morgan Stanley.
---------------------------------------------------------------------------

    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.\1309\
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.\1310\
---------------------------------------------------------------------------

    \1309\ Thus, the Agencies agree with one commenter who stated
that compensation for hedging should not be based purely on profits
derived from hedging. However, the final rule does not require
compensation vesting, as suggested by this commenter, because the
Agencies believe the final hedging exemption includes sufficient
requirements to ensure that only risk-mitigating hedging is
permitted under the exemption without a compensation vesting
provision. See AFR et al. (Feb. 2012); AFR (June 2013).
    \1310\ See 12 U.S.C. 5641.
---------------------------------------------------------------------------

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.\1311\ 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.
---------------------------------------------------------------------------

    \1311\ For example, as explained under the proposal, a hedge
would be established at a different level of organization of the
banking entity if multiple market-making desks were exposed to
similar risks and, to hedge such risks, a hedge was established at
the direction of a supervisor or risk manager responsible for more
than one desk rather than at each of the market-making desks that
established the initial positions, contracts, or other holdings. See
Joint Proposal, 76 FR 68,876 n.161.
---------------------------------------------------------------------------

    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.\1312\ 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.\1313\
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.\1314\
---------------------------------------------------------------------------

    \1312\ See AFR (June 2013); Occupy.
    \1313\ See Occupy.
    \1314\ See Sens. Merkley & Levin (Feb. 2012); Occupy; AFR (June
2013).
---------------------------------------------------------------------------

    Some commenters requested that the documentation requirement be
applied at a higher level of organization,\1315\ and some commenters
noted that policies and procedures alone would be sufficient to address
hedging activity, wherever conducted within the organization.\1316\ 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.\1317\ 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.\1318\
---------------------------------------------------------------------------

    \1315\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC;
Barclays; See also Japanese Bankers Ass'n.
    \1316\ See JPMC; SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1317\ See JPMC; Barclays.
    \1318\ See Barclays; JPMC; SIFMA et al. (Prop. Trading) (Feb.
2012); See also Japanese Bankers Ass'n.
---------------------------------------------------------------------------

    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.\1319\
---------------------------------------------------------------------------

    \1319\ See JPMC.
---------------------------------------------------------------------------

    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 Sec.  ----.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.\1320\ 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.
---------------------------------------------------------------------------

    \1320\ One commenter suggested that the rule require
documentation when a banking entity needs to engage in new types of
hedging transactions that are not covered by its hedging policies,
although this commenter's suggested approach would only apply when a
hedge is conducted two levels above the level at which the risk
arose. See SIFMA et al. (Prop. Trading) (Feb. 2012). The Agencies
agree that documentation is needed when a trading desk is acting
outside of its hedging policies and procedures. However, the final
rule does not limit this documentation requirement to circumstances
when the hedge is conducted two organizational levels above the
trading desk. Such an approach would be less effective than the
adopted approach at addressing evasion concerns.
---------------------------------------------------------------------------

    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.\1321\ 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.
---------------------------------------------------------------------------

    \1321\ See final rule Sec.  ----5(c)(3).
---------------------------------------------------------------------------

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,\1322\ 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.\1323\ 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.
---------------------------------------------------------------------------

    \1322\ See proposed rule Sec.  ----.6.
    \1323\ See 12 U.S.C. 1851(d)(1)(A), (C), (F), and (H).
---------------------------------------------------------------------------

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.\1324\ 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.).\1325\ 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.\1326\
---------------------------------------------------------------------------

    \1324\ 12 U.S.C. 1851(d)(1)(A).
    \1325\ The Agencies proposed that United States ``agencies'' for
this purpose would include those agencies described in section
201.108(b) of the Board's Regulation A. See 12 CFR 201.108(b). The
Agencies also noted that the terms of the exemption would encompass
the purchase or sale of enumerated government obligations on a
forward basis (e.g., in a to-be-announced market). In addition, this
would include pass-through or participation certificates that are
issued and guaranteed by a government-sponsored entity (e.g., the
Federal National Mortgage Association and the Federal Home Loan
Mortgage Corporation) in connection with its securitization
activities.
    \1326\ See Joint Proposal, 76 FR 68,878.
---------------------------------------------------------------------------

    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.\1327\ 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.\1328\ 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.\1329\ 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.\1330\ 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.\1331\
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.\1332\ 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.\1333\ Two commenters
opposed providing an exemption for proprietary trading in derivatives
on exempt government obligations.\1334\
---------------------------------------------------------------------------

    \1327\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);
Sens. Merkley & Levin (Feb. 2012).
    \1328\ See BoA; CalPERS; Credit Suisse (Seidel); CME Group;
Fixed Income Forum/Credit Roundtable; FIA; JPMC; Morgan Stanley;
PNC; SIFMA et al. (Prop. Trading) (Feb. 2012); Wells Fargo (Prop.
Trading).
    \1329\ See BoA; FIA; HSBC; JPMC; Morgan Stanley; Wells Fargo
(Prop. Trading).
    \1330\ See Barclays; Credit Suisse (Seidel); Fixed Income Forum/
Credit Roundtable; FIA.
    \1331\ See Barclays; CME Group; Fixed Income Forum/Credit
Roundtable; See also UBS.
    \1332\ See CME Group; See also Morgan Stanley; PNC; SIFMA et al.
(Prop. Trading) (Feb. 2012); Wells Fargo (Prop. Trading).
    \1333\ See Barclays; CME Group; JPMC.
    \1334\ See Occupy; Alfred Brock.
---------------------------------------------------------------------------

    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.\1335\ 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 Sec. Sec.  ----.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 Sec.  ----.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 Sec. Sec.  ----.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,\1336\ 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.\1337\ 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.\1338\
---------------------------------------------------------------------------

    \1335\ See infra note 1330.
    \1336\ See infra Part IV.A.3.c.2.c.i.
    \1337\ See supra note 905 (explaining the functions of primary
dealers).
    \1338\ See supra Part IV.A.3.c.2.b.ix. (discussing commenters'
concerns regarding primary dealer activity, as well as one
commenter's request for such an interpretation).
---------------------------------------------------------------------------

    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.\1339\ 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.
---------------------------------------------------------------------------

    \1339\ See final rule Sec.  ----.6(a)(4).
---------------------------------------------------------------------------

b. 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.\1340\
---------------------------------------------------------------------------

    \1340\ See Joint Proposal, 76 FR 68,878.
---------------------------------------------------------------------------

    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.\1341\ 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.\1342\ 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.\1343\
---------------------------------------------------------------------------

    \1341\ See, e.g., Allen & Overy (Gov't Obligations); Allen &
Overy (Canadian Banks); BoA; Australian Bankers Ass'n. (Feb. 2012);
AFMA; Banco de M[eacute]xico; Bank of Canada; Ass'n of German Banks;
BAROC; Barclays; BEC (citing the National Institute of Banking and
Finance); British Bankers' Ass'n.; BaFin/Deutsche Bundesbank;
Chamber (Feb. 2012); Mexican Banking Comm'n.; French Treasury et
al.; EFAMA; ECOFIN; EBF; French Banking Fed'n.; FSA (Apr. 2012);
FIA; Goldman (Prop. Trading); HSBC; Hong Kong Inv. Funds
Association; IIB/EBF; ICFR; ICSA; IRSG; Japanese Bankers Ass'n.;
Ass'n. of Banks in Malaysia; OSFI; British Columbia; Qu[eacute]bec;
Sumitomo Trust; TMA Hong Kong; UBS; Union Asset.
    \1342\ See, e.g., Allen & Overy (Gov't Obligations); Bank of
Canada; British Columbia; Ontario; IIAC; Quebec; IRSG; IIB/EBF;
Mitsubishi; Gov't of Japan/Bank of Japan; Australian Bankers Ass'n
(Feb. 2012); AFMA; Banco de M[eacute]xico; Ass'n. of German Banks;
ALFI; Embassy of Switzerland.
    \1343\ See Ass'n. of German Banks; Goldman (Prop. Trading); IIB/
EBF; ICFR; FIA; Mitsubishi; Sumitomo Trust; Allen & Overy (Gov't
Obligations).
---------------------------------------------------------------------------

    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.\1344\ 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.\1345\ 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.\1346\
---------------------------------------------------------------------------

    \1344\ See Allen & Overy (Gov't. Obligations); Banco de
M[eacute]xico; Barclays; BaFIN/Deutsche Bundesbank; EFAMA; Union
Asset; TMA Hong Kong; ICI (Feb. 2012) (arguing that such an
exemption would be consistent with Congressional intent to limit the
extra-territorial application of U.S. law).
    \1345\ See Banco de M[eacute]xico; Barclays; BoA; Gov't of
Japan/Bank of Japan; IIAC; OSFI.
    \1346\ See, e.g., Allen & Overy (Gov't. Obligations); AFMA;
Banco de M[eacute]xico; Ass'n. of German Banks; Barclays; Mexican
Banking Comm'n.; EFAMA; EBF; French Banking Fed'n.; Goldman (Prop.
Trading); HSBC; IIB/EBF; HSBC; ICSA; T. Rowe Price; UBS; Union
Asset; IRSG; EBF; Mitsubishi (citing Japanese Bankers Ass'n. and
IIB); Wells Fargo (Prop. Trading); ICI Global.
---------------------------------------------------------------------------

    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.\1347\ 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.\1348\ 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.\1349\ 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.\1350\ 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.\1351\ 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.\1352\
---------------------------------------------------------------------------

    \1347\ See Allen & Overy (Gov't. Obligations) (contending that
``even if not primary dealers, banking entities or their branches or
agencies acting in certain foreign jurisdictions, such as Singapore
and India, are still required to hold or transact in local sovereign
debt under local law''); BoA; Barclays; Citigroup; SIFMA et al.
(Prop. Trading) (Feb. 2012).
    \1348\ See Allen & Overy (Gov't. Obligations); Australian
Bankers Ass'n. (Feb. 2012); BoA; Banco de M[eacute]xico; Barclays;
Citigroup; Goldman (Prop. Trading); IIB/EBF; See also JPMC
(suggesting that, at a minimum, the Agencies should make clear that
all of a firm's activities that are necessary or reasonably
incidental to its acting as a primary dealer in a foreign
government's debt securities are protected by the market-making-
related permitted activity); SIFMA et al. (Prop. Trading) (Feb.
2012). As discussed in Parts IV.A.2.c.2.c. and IV.A.2.c.2.b.ix of
this SUPPLEMENTARY INFORMATION, the Agencies believe primary dealing
activities would generally qualify under the scope of the market-
making or underwriting exemption.
    \1349\ See Citigroup; SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1350\ See Allen & Overy (Gov't. Obligations); BoA.
    \1351\ See Barclays; IIAC; UBS; Ass'n. of Banks in Malaysia;
IIB/EBF.
    \1352\ See Comm. on Capital Markets Regulation.

---------------------------------------------------------------------------

    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.\1353\ 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.\1354\ 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.\1355\
---------------------------------------------------------------------------

    \1353\ See Allen & Overy (Gov't. Obligations); Banco de
M[eacute]xico; IIB/EBF; Ass'n. of Banks in Malaysia.
    \1354\ See Sumitomo Trust; SIFMA et al. (Prop. Trading) (Feb.
2012); Allen & Overy (Govt. Obligations); BoA; ICI Global; RBC;
ICFR; ICI (Feb. 2012); Bank of Canada; Cadwalader (on behalf of
Singapore Banks); Ass'n. of Banks in Malaysia; Cadwalader (on behalf
of Thai Banks); Chamber (Feb. 2012); BAROC. See also IIB/EBF.
    \1355\ See Sens. Merkley &Levin (Feb. 2012).
---------------------------------------------------------------------------

    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.\1356\ 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).\1357\ 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.\1358\ 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.\1359\
---------------------------------------------------------------------------

    \1356\ See Cadwalader (on behalf of Thai Banks); IIB/EBF; Ass'n.
of Banks in Malaysia; UBS; See also BAROC.
    \1357\ See BoA; Cadwalader (on behalf of Singapore Banks); IIB/
EBF; Norinchukin; OSFI; Cadwalader (on behalf of Thai Banks); Ass'n.
of Banks in Malaysia; UBS; See also BAROC; ICFR; Japanese Bankers
Ass'n.; JPMC; Qu[eacute]bec.
    \1358\ See, e.g., Allen & Overy (Gov't Obligations).
    \1359\ See Allen & Overy (Gov't. Obligations); HSBC.
---------------------------------------------------------------------------

    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.\1360\ 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.\1361\ 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.\1362\
---------------------------------------------------------------------------

    \1360\ See Better Markets (Feb. 2012); Occupy; Prof. Johnson;
Sens. Merkley & Levin (Feb. 2012).
    \1361\ See Prof. Johnson; Better Markets (Feb. 2012).
    \1362\ See Better Markets (Feb. 2012); See also Prof. Johnson.
---------------------------------------------------------------------------

    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.\1363\ 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.\1364\ The
final rule continues to incorporate this view.\1365\
---------------------------------------------------------------------------

    \1363\ See final rule Sec.  ----.6(e).
    \1364\ See Joint Proposal, 76 FR 68,862.
    \1365\ See final rule Sec.  ----.3(d)(3).
---------------------------------------------------------------------------

    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 Sec.  ----.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.\1366\

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 political subdivisions of the foreign banking entity's home
country.\1367\
---------------------------------------------------------------------------

    \1366\ See final rule Sec.  ----.6(b). Some commenters requested
an exemption for trading in obligations of multinational central
banks. See Ass'n. of German Banks; Goldman (Prop. Trading); IIB/EBF;
ICFR; FIA; Mitsubishi; Sumitomo Trust; Allen & Overy (Gov't.
Obligations). In the case of a foreign banking entity that is owned
or controlled by a second foreign banking entity domiciled in a
country other than the home country of the first foreign banking
entity, the final rule would permit the eligible U.S. operations of
the first foreign banking entity to engage in proprietary trading
only in the sovereign debt of the first foreign banking entity's
home country, and would permit the U.S. operations of the second
foreign banking entity to engage in proprietary trading only in the
sovereign debt of the home country of the second foreign banking
entity. As noted earlier, other provisions of the final rule make
clear that the rule does not restrict the proprietary trading
outside of the United States of either foreign banking organization
in debt of any foreign sovereign.
    \1367\ See Part IV.A.5.c., infra. Many commenters requested an
exemption for trading in foreign sovereign debt, including
obligations issued by political subdivisions of foreign governments.
See, e.g., Allen & Overy (Gov't. Obligations); BoA; Australian
Bankers Ass'n. (Feb. 2012); Banco de M[eacute]xico; Bank of Canada;
Ass'n. of German Banks; BAROC; Barclays.
---------------------------------------------------------------------------

    Permitting the eligible U.S. operations of a foreign banking entity
to engage in proprietary trading in the United States in the foreign
sovereign obligations of the foreign entity's home country allows these
U.S. operations of foreign banking entities to continue to support the
smooth functioning of markets in foreign sovereign obligations in the
same manner as U.S. banking entities are permitted to support the
smooth functioning of markets in U.S. government and agency
obligations.\1368\ At the same time, the risk of these trading
activities is largely determined by the foreign sovereign that charters
the foreign bank. By not permitting proprietary trading in foreign
sovereign debt in insured depository institutions (other than in
accordance with the limitations in other exemptions), the exemption
limits the direct risks of these activities to insured depository
institutions in keeping with the statute.\1369\ Thus, the Agencies have
determined that this limited exemption for proprietary trading in
foreign sovereign obligations promotes and protects the safety and
soundness of banking entities and also promotes and protects the
financial stability of the United States.
---------------------------------------------------------------------------

    \1368\ As part of this exemption, for example, the U.S.
operations of a European bank would be able to trade in obligations
issued by the European Central Bank. Many commenters represented
that the same rationale for exempting trading in U.S. government
obligations supports exempting trading in foreign sovereign debt.
See, e.g., Allen & Overy (Gov't. Obligations); Banco de
M[eacute]xico; Barclays; EFAMA; ICI (Feb. 2012).
    \1369\ The Agencies believe this approach appropriately balances
commenter concerns that proprietary trading in foreign sovereign
obligations represents a risky activity and the interest in
preserving the ability of U.S. operations of foreign banking
entities to continue to support the smooth functioning of markets in
foreign sovereign obligations in the same manner as U.S. banking
entities are permitted to support the smooth functioning of markets
in U.S. government and agency obligations. See Better Markets (Feb.
2012); Occupy; Prof. Johnson; Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

    The Agencies have also determined to permit a foreign bank or
foreign broker-dealer regulated as a securities dealer and controlled
by a U.S. banking entity to engage in proprietary trading in the
obligations of the foreign sovereign under whose laws the foreign
entity is organized (hereinafter, the ``home country''), including
obligations of an agency or political subdivision of that foreign
sovereign.\1370\ This limited exemption is necessary to allow U.S.
banking organizations to continue to own and acquire foreign banking
organizations and broker-dealers without requiring those foreign
banking organizations and broker-dealers to discontinue proprietary
trading in the sovereign debt of the foreign banking entity's home
country.\1371\ The Agencies have determined that this limited exemption
will promote the safety and soundness of banking entities and the
financial stability of the United States by allowing U.S. banking
entities to continue to be affiliated with and operate foreign banking
entities and benefit from international diversification and
participation in global financial markets.\1372\ However, the Agencies
intend to monitor activity of banking entities under this exemption to
ensure that U.S. banking entities are not seeking to evade the
restrictions of section 13 by using an affiliated foreign bank or
broker-dealer to engage in proprietary trading in foreign sovereign
debt on behalf of or for the benefit of other parts of the U.S. banking
entity.
---------------------------------------------------------------------------

    \1370\ See final rule Sec.  ----.6(c). Many commenters requested
an exemption for trading in foreign sovereign debt, and some
commenters suggested exempting proprietary trading by foreign
banking entities in obligations of their home country. See, e.g.,
Allen & Overy (Gov't. Obligations); BoA; FSA (Apr. 2012); Cadwalader
(on behalf of Thai Banks); IIB/EBF; Ass'n. of Banks in Malaysia;
UBS.
    \1371\ Commenters argued that in some foreign markets, U.S.
banks operating in those jurisdictions are required by local
regulation or market practice to trade in local sovereign
securities. See, e.g., Allen & Overy (Gov't. Obligations); AFMA;
Ass'n. of German Banks; Barclays; EBF; Goldman (Prop. Trading); UBS.
    \1372\ Some commenters represented that the limitations and
obligations of section 13 would be problematic and unduly burdensome
on banking entities because they would only be able to trade in
foreign sovereign obligations under existing exemptions, such as the
market-making exemption. See Barclays; IIAC; UBS; Ass'n. of Banks in
Malaysia; IIB/EBF.
---------------------------------------------------------------------------

    Apart from this limited exemption, the Agencies have not extended
this exemption to proprietary trading in foreign sovereign debt by U.S.
banking entities for several reasons. First, section 13 was primarily
concerned with the risks posed to the U.S. financial system by
proprietary trading activities. This risk is most directly transmitted
by U.S. banking entities, and while commenters alleged that prohibiting
U.S. banking entities from engaging in proprietary trading in debt of
foreign sovereigns would harm liquidity in those markets, the evidence
provided by commenters did not sufficiently indicate that permitting
U.S. banking entities to engage in proprietary trading (as opposed to
market-making or underwriting) in debt of foreign sovereigns
contributed in any significant degree to the liquidity of markets in
foreign sovereign instruments.\1373\ Thus, expanding the exemption to
permit U.S. banking entities to engage in proprietary trading in debt
of foreign sovereigns would likely increase the risks to these entities
and the U.S. financial system without a significant concomitant and
offsetting benefit. As explained above, these U.S. entities are
permitted by the final rule to continue to engage fully in market-
making in and underwriting of debt of foreign sovereigns anywhere in
the world. The only restriction placed on these entities is on the
otherwise impermissible proprietary trading in these instruments 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.
---------------------------------------------------------------------------

    \1373\ See, e.g., BoA; Citigroup; Goldman (Prop. Trading); IIB/
EBF; Allen & Overy (Gov't. Obligations); Australian Bankers Ass'n.
(Feb. 2012).; Banco de M[eacute]xico; Barclays. The Agencies
recognize some commenters' representation that restricting trading
in foreign sovereign debt would not necessarily cause reduced
liquidity in government bond markets because banking entities would
still be able to make a market in and underwrite foreign government
obligations. See Prof. Johnson; Better Markets (Feb. 2012).
---------------------------------------------------------------------------

    The Agencies recognize that, depending on the extent to which
banking entities subject to the rule have contributed to the liquidity
of trading markets for foreign sovereign debt, the lack of an exemption
for proprietary trading in foreign sovereign debt could result in
certain negative impacts on the markets for such debt. In general, the
Agencies believe these concerns should be mitigated somewhat by the
refined exemptions for market making, underwriting and permitted
trading activity of foreign banking entities; however, those exemptions
do not address certain of the collateral, capital, and other
operational issues identified by commenters.\1374\ Foreign sovereign

debt of home and host countries generally serves these purposes. Due to
the relationships among global financial markets, permitting trading
that supports these essential functions promotes the financial
stability and the safety and soundness of banking entities.\1375\ In
contrast, a broad exemption for proprietary trading in all foreign
sovereign debt without the limitations contained in the underwriting,
market making and hedging exemptions could lead to more complicated
risk profiles and significant unhedged risk exposures that section 13
of the BHC Act is designed to address. Thus, the Agencies believe use
of section 13(d)(1)(J) exemptive authority to permit proprietary
trading in foreign government obligations in certain limited
circumstances is appropriate.
---------------------------------------------------------------------------

    \1374\ Representatives from foreign governments stated that an
exemption allowing trading in obligations of their governments is
necessary to maintain financial stability in their markets. See,
e.g., Allen & Overy (Gov't. Obligations); Bank of Canada; IRSG; IIB/
EBF; Gov't of Japan/Bank of Japan; Australian Bankers Ass'n. (Feb.
2012); Banco de M[eacute]xico; Ass'n. of German Banks; ALFI.
Commenters argued that exempting trading in foreign sovereign debt
would avoid the possible negative impacts of a contraction of
government bond market liquidity. See, e.g., BoA; Citigroup; Goldman
(Feb. 2012); IIB/EBF. Additionally, commenters suggested that
failing to provide an exemption for this activity would impact money
market operations of foreign central banks and limit the ability of
foreign sovereign governments to conduct monetary policy or finance
their operations. See, e.g., Barclays; BoA; Gov't of Japan/Bank of
Japan; OSFI. A number of commenters also argued that, since U.S. and
foreign banking entities often perform functions for foreign
governments similar to those provided in the U.S. by U.S. primary
dealers, the lack of an exemption would have a significant, negative
impact on the ability of foreign governments to implement monetary
policy and on liquidity in many foreign markets. See, e.g., Allen &
Overy (Gov't. Obligations); Australian Bankers Ass'n. (Feb. 2012);
BoA; Banco de M[eacute]xico; Barclays; Citigroup (Feb. 2012);
Goldman (Prop. Trading); IIB/EBF. Some commenters argued that
banking entities and their customers use foreign sovereign debt to
manage their risk by posting collateral in foreign jurisdictions and
to manage international rate and foreign exchange risk. See
Citigroup (Feb. 2012); SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1375\ The Agencies generally concur with commenters' concerns
that because the lack of an exemption could result in negative
consequences--such as harming liquidity in foreign sovereign debt
markets, making it more difficult and more costly for foreign
governments to fund themselves, or subjecting banking entities to
increased concentration risk--systemic risk could increase or there
could be spillover effects that would harm global markets, including
U.S. markets. See IIF; EBF; ICI Global; HSBC; Barclays; ICI (Feb.
2012); IIB/EBF; Union Asset. Additionally, in consideration of one
commenter's statements, the Agencies believe that failing to provide
this exemption may cause foreign banks to close their U.S. branches,
which could harm U.S. markets. See Comm. on Capital Markets
Regulation.
---------------------------------------------------------------------------

    The Agencies decline to follow commenters' suggested alternative of
allowing trading in foreign government obligations if the obligations
meet a particular condition on quality, such as obligations of OECD
member countries.\1376\ The Agencies do not believe such an approach
responds to the statutory purpose of limiting risks posed to the U.S.
financial system by proprietary trading activities as directly as our
current approach, which is structured to limit the exposure of banking
entities, including insured depository institutions, to the risks of
foreign sovereign debt. Additionally, the Agencies decline to permit
proprietary trading in any obligation permitted under the laws of the
foreign banking entity's home country,\1377\ because such an approach
could result in unintended competitive impacts since banking entities
would not be subject to one uniform standard inside the United States.
Further, unlike some commenters, the Agencies do not believe it is
appropriate to require foreign governments to commit to paying for any
damage to the U.S. financial system resulting from the foreign
sovereign debt exemption.\1378\
---------------------------------------------------------------------------

    \1376\ See, e.g., BoA; Cadwalader (on behalf of Singapore
Banks).; IIB/EBF; OSFI; UBS; BAROC; Japanese Bankers Ass'n.; JPMC.
    \1377\ Some commenters suggested permitting non-U.S. banking
entities to trade in any government obligation to the extent that
such trading is permitted by the entity's primary regulator. See
Allen & Overy (Gov't. Obligations); HSBC.
    \1378\ See Better Markets (Feb. 2012); See also Prof. Johnson.
---------------------------------------------------------------------------

    The proposal also did not contain an exemption for trading in
derivatives on foreign government obligations. Many commenters who
recommended providing an exemption for proprietary trading in foreign
government obligations also requested that the exemption be extended to
derivatives on foreign government obligations.\1379\ Two of these
commenters urged that trading in derivatives on foreign sovereign
obligations should be exempt for the same reason that trading in
derivatives on U.S. government obligations is exempt because such
trading supports liquidity and price stability in the market for the
underlying government obligations.\1380\ One commenter recommended that
the Agencies use the authority in section 13(d)(1)(J) to grant an
exemption for proprietary trading in derivatives on foreign government
obligations.\1381\
---------------------------------------------------------------------------

    \1379\ See Barclays; Credit Suisse (Seidel); IIB/EBF; Japanese
Bankers Ass'n.; Norinchukin; RBC; Sumitomo Trust; UBS.
    \1380\ See Barclays; FIA.
    \1381\ See Barclays.
---------------------------------------------------------------------------

    The final rule has not been modified in Sec.  ----.6(b) to permit a
banking entity to engage in proprietary trading in derivatives on
foreign government obligations. As noted above, the Agencies have
determined not to permit proprietary trading in derivatives on U.S.
exempt government obligations under section 13(d) and, for the same
reasons, have determined not to extend the permitted activities to
include proprietary trading in derivatives on foreign government
obligations.
c. Permitted Trading in Municipal Securities
    Section ----.6(a) of the proposed rule implemented an exemption to
the prohibition against proprietary trading under section 13(d)(1)(A)
of the BHC Act, which permits trading in certain governmental
obligations. This exemption permits the purchase or sale of obligations
issued by any State or any political subdivision thereof (the
``municipal securities trading exemption''). The proposed rule included
both general obligation bonds and limited obligation bonds, such as
revenue bonds, within the scope of this municipal securities trading
exemption. The proposed rule, however, did not extend to obligations of
``agencies'' of States or political subdivisions thereof.\1382\
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    \1382\ See Joint Proposal, 76 FR 68,878 n.165.
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    Many commenters, including industry participants, trade groups, and
Federal and state governmental representatives, argued that the
municipal securities trading exemption should be interpreted to permit
banking entities to engage in proprietary trading in a broader range of
municipal securities, including the following: Obligations issued
directly by States and political subdivisions thereof; obligations
issued by agencies, constituted authorities, and similar governmental
entities acting as instrumentalities on behalf of States and political
subdivisions thereof; and obligations issued by such governmental
entities that are treated as political subdivisions under various more
expansive definitions of political subdivisions under Federal and state
laws.\1383\ These commenters argued that States and municipalities
often issue obligations through agencies and instrumentalities and that
these obligations generally have the same level of risk as direct
obligations of States and political subdivisions.\1384\ Commenters
asserted that permitting trading in a broader group of municipal
securities would be consistent with the

terms and purposes of section 13 and would not adversely affect the
safety and soundness of banking entities involved in these transactions
or create additional risk to the financial stability of the United
States.\1385\
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    \1383\ See, e.g., ABA (Keating); Ashurst; Ass'n. of
Institutional Investors (Feb. 2012); BoA; BDA (Feb. 2012); Capital
Group; Chamber (Feb. 2012); Citigroup (Jan. 2012); CHFA; Eaton
Vance; Fidelity; Fixed Income Forum/Credit Roundtable; HSBC; MEFA;
Nuveen Asset Mgmt.; Sens. Merkley & Levin (Feb. 2012); Am. Pub.
Power et al.; MSRB; Fidelity; State of New York; STANY; SIFMA
(Municipal Securities) (Feb. 2012); State Street (Feb. 2012); North
Carolina; T. Rowe Price; Sumitomo Trust; UBS; Washington State
Treasurer; Wells Fargo (Prop. Trading).
    \1384\ See, e.g., CHFA; Sens. Merkley & Levin (Feb. 2012); Am.
Pub. Power et al.; North Carolina; Washington State Treasurer; See
also NABL; Ashurst; BDA (Feb. 2012); Chamber (Feb. 2012); Eaton
Vance; Fidelity; MEFA; MSRB; Am. Pub. Power et al.; Nuveen Asset
Mgmt.; PNC; SIFMA (Municipal Securities) (Feb. 2012); UBS.
    \1385\ See Ashurst; Citigroup (Jan. 2012); Eaton Vance; Am. Pub.
Power et al.; SIFMA (Municipal Securities) (Feb. 2012); North
Carolina; T. Rowe Price; Wells Fargo (Prop. Trading); See also
Capital Group (arguing that municipal securities are not generally
used as a profit making strategy and thus, including all municipal
securities in the exemption by itself should not adversely affect
the safety and soundness of banking entities); PNC (arguing that the
safe and sound nature of trading in State and municipal agency
obligations was ``a fact recognized by Congress in 1999 when it
authorized well capitalized national banks to underwrite and deal
in, without limit, general obligation, limited obligation and
revenue bonds issued by or on behalf of any State, or any public
agency or authority of any State or political subdivision of a
State''); Sens. Merkley & Levin (Feb. 2012).
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    Commenters expressed concerns that the proposed rule would result
in a bifurcation of the municipal securities market that would achieve
no meaningful benefits to the safety and soundness of banking entities,
create administrative burdens for determining whether or not a
municipal security qualifies for the exemption, result in inconsistent
applications across different States, increase costs, and decrease
liquidity in the diverse municipal securities market.\1386\ Commenters
also argued that the market for securities issued by agencies and
instrumentalities of States and political subdivisions thereof would be
especially disrupted, and would affect about 40 percent of the
municipal securities market.\1387\
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    \1386\ See, e.g., MSRB; City of New York; Am. Pub. Power et al.;
Wells Fargo; State of New York; Washington State Treasurer; ABA
(Keating); Capital Group; North Carolina; Eaton Vance; Port
Authority; Connecticut; Citigroup (Jan. 2012); Ashurst; Nuveen Asset
Mgmt.; SIFMA (Municipal Securities) (Feb. 2012).
    \1387\ See, e.g., MSRB (stating that, based on data from Thomson
Reuters, 41.4 percent of the municipal securities issued in FY 2011
were issued by agencies and authorities).
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    Commenters recommended that the final rule provide a broad
exemption to the prohibition on proprietary trading for municipal
securities, based on the definition of ``municipal securities'' used in
section 3(a)(29) of the Exchange Act,\1388\ which is understood by
market participants and by Congress, and has a well-settled meaning and
an established body of law. \1389\ Other commenters contended that
adopting the same definition of municipal securities as used in the
Federal securities laws would reduce regulatory burden, remove
uncertainty, and lead to consistent treatment of these securities under
the banking and securities laws.\1390\ According to some commenters,
the terms ``agency'' and ``political subdivision'' are used differently
under some State laws, and some State laws identify certain agencies as
political subdivisions or define political subdivision to include
agencies.\1391\ Commenters also noted that a number of Federal statutes
and regulations define the term ``political subdivision'' to include
municipal agencies and instrumentalities.\1392\ Commenters suggested
that the Agencies interpret the term ``political subdivision'' in
section 13 more broadly than in the proposal to include a wider range
of State and municipal governmental obligations issued by agencies and
instrumentalities or, alternatively, that the Agencies use the
exemptive authority in section 13(d)(1)(J) if necessary to permit
proprietary trading of a broader array of State and municipal
obligations.\1393\
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    \1388\ See 15 U.S.C. 78c(a)(29).
    \1389\ See ABA (Keating); Ashurst; BoA; Capital Group; Chamber
(Feb. 2012); Comm. on Capital Markets Regulation; Citigroup (Jan.
2012); Eaton Vance; Fidelity; MEFA; MTA-NY; MSRB; Am. Pub. Power et
al.; NABL; NCSL; State of New York; Nuveen Asset Mgmt.; Port
Authority; PNC; SIFMA (Municipal Securities) (Feb. 2012); North
Carolina; T. Rowe Price; UBS; Washington State Treasurer; Wells
Fargo (Prop. Trading).
    \1390\ See Ashurst; Citigroup (Jan. 2012) (noting that the
National Bank Act explicitly lists State agencies and authorities as
examples of political subdivisions); MSRB.
    \1391\ See, e.g., Citigroup (Jan. 2012).
    \1392\ See, e.g., MSRB; Citigroup (Jan. 2012). In addition to
the Federal securities laws, the National Bank Act explicitly
includes agencies and authorities as examples of political
subdivisions. See 12 U.S.C. 24(seventh) (permitting investments in
securities ``issued by or on behalf of any State or political
subdivision of a State, including any municipal corporate
instrumentality of 1 or more States, or any public agency or
authority of any State or political subdivision of a State . . .
.''). In addition, a number of banking regulations also include
agencies as examples of political subdivisions or define political
subdivision to include municipal agencies, authorities, districts,
municipal corporations and similar entities. See, e.g., 12 CFR 1.2;
12 CFR 160.30; 12 CFR 161.38; 12 CFR 330.15. Further, for purposes
of the tax-exempt bond provisions in the Internal Revenue Code,
Treasury regulations treat obligations issued by or ``on behalf of''
States or political subdivisions by ``constituted authorities'' as
obligations of such States or political subdivisions, and the
Treasury regulations define the term ``political subdivision'' to
mean ``any division of any State or local governmental unit which is
a municipal corporation or which has been delegated the right to
exercise part of the sovereign power of the unit. . . .'' See 26 CFR
1.103-1(b).
    \1393\ See ABA (Keating); Ashurst; Ass'n. of Institutional
Investors (Feb. 2012); Citigroup (Jan. 2012); Comm. on Capital
Markets Regulation; Sens. Merkley & Levin (Feb. 2012); MSRB; Wells
Fargo (Prop. Trading); SIFMA et al. (Prop. Trading) (Feb. 2012).
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    On the other hand, one commenter contended that bonds issued by
agencies and instrumentalities of States or municipalities pose risks
to the banking system because the commenter believed the market for
these bonds has not been properly regulated or controlled.\1394\ A few
commenters also recommended tightening the proposed municipal
securities trading exemption to exclude conduit obligations that
benefit private businesses and private organizations.\1395\ One
commenter suggested that the proposed municipal securities trading
exemption should not apply to tax-exempt municipal bonds that benefit
private businesses (referred to as ``private activity bonds'' in the
Internal Revenue Code\1396\) and that allow private businesses to
finance private projects at lower interest rates as a result of the
exemption from Federal income taxation for the interest received by
investors.\1397\
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    \1394\ See Occupy.
    \1395\ See AFR et al. (Feb. 2012); Occupy.
    \1396\ See 26 U.S.C. 141. In general, the rules applicable to
the issuance of tax-exempt private activity bonds under the Internal
Revenue Code of 1986, as amended (the ``Code'') are more restrictive
than those applicable to traditional governmental bonds issued by
States or political subdivisions thereof. Section 146 of the Code
imposes an annual State bond volume cap on most tax-exempt private
activity bonds that is tied to measures of State populations.
Sections 141-150 of the Code impose other additional restrictions on
tax-exempt private activity bonds, including, among others, eligible
project and use restrictions, bond maturity restrictions, land and
existing property financing restrictions, an advance refunding
prohibition, and a public approval requirement.
    \1397\ See AFR et al. (Feb. 2012).
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    The final rule includes the statutory exemption for proprietary
trading of obligations of any State or political subdivision
thereof.\1398\ In response to the public comments and for the reasons
discussed below, this exemption uses the definition of the term
``municipal security'' modeled after the definition of ``municipal
securities'' under section 3(a)(29) of the Exchange Act,\1399\ but

with simplifications.\1400\ The final rule defines the term ``municipal
security'' to mean ``a security which is a direct obligation of or
issued by, or an obligation guaranteed as to principal or interest by,
a State or any political subdivision thereof, or any agency or
instrumentality of a State or any political subdivision thereof, or any
municipal corporate instrumentality of one or more States or political
subdivisions thereof.''
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    \1398\ See final rule Sec.  ----.6(a)(3).
    \1399\ Many commenters requested that the final rule use the
definition of ``municipal securities'' used in the federal
securities laws because, among other reasons, the industry is
familiar with that definition and such an approach would promote
consistent treatment of these securities under banking and
securities laws. See, e.g., ABA (Keating); Ashurst; BoA; Comm. on
Capital Markets Regulation; Citigroup (Jan. 2012); NCSL; Port
Authority; SIFMA (Municipal Securities) (Feb. 2012); MSRB. Section
3(a)(29) of the Exchange Act defines the term ``municipal
securities'' to mean ``securities which are direct obligations of,
or obligations guaranteed as to principal or interest by, a State or
any political subdivision thereof, or any agency or instrumentality
of a State or any political subdivision thereof, or any municipal
corporate instrumentality of one or more States, or any security
which is an industrial development bond (as defined in section
103(c)(2) of Title 26) the interest on which is excludable from
gross income under section 103(a)(1) of Title 26 if, by reason of
the application of paragraph (4) or (6) of section 103(c) of Title
26 (determined as if paragraphs (4)(A), (5), and (7) were not
included in such section 103(c)), paragraph (1) of such section
103(c) does not apply to such security.'' See 15 U.S.C. 78c(a)(29).
    \1400\ The definition of municipal securities in section
3(a)(29) of the Exchange Act has outdated tax references to the
prior law under the former Internal Revenue Code of 1954, including
particularly references to certain provisions involving the concept
of ``industrial development bonds.'' The successor current Internal
Revenue Code of 1986, as amended, replaces the prior definition of
``industrial development bonds'' with a revised, more restrictive
successor definition of ``private activity bonds'' and related
definitions of ``exempt facility bonds'' and ``small issue bonds.''
In recognition of the numerous tax law changes since the last
statutory revision of section 3(a)(29) of the Exchange Act in 1970
and the potential attendant confusion, the Agencies determined to
use a simpler, streamlined, independent definition of municipal
securities for purposes of the municipal securities trading
exception. This revised definition is intended to encompass, among
others, any securities that are covered by the definition of the
term ``municipal securities'' under section 3(a)(29) of the Exchange
Act.
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    The final rule modifies the proposal to permit proprietary trading
in obligations issued by agencies and instrumentalities acting on
behalf of States and municipalities (e.g., port authority bonds and
bonds issued by municipal agencies or corporations).\1401\ As noted by
commenters, many States and municipalities rely on securities issued by
agencies and instrumentalities to fund essential activities, including
utility systems, infrastructure projects, affordable housing,
hospitals, universities, and other nonprofit institutions.\1402\ Both
obligations issued directly by States and political subdivisions
thereof and obligations issued by an agency or instrumentality of such
a State or local governmental entity are ultimately obligations of the
State or local governmental entity on whose behalf they act. Moreover,
exempting obligations issued by State and municipal agencies and
instrumentalities in the same manner as the direct obligations of
States and municipalities lessens potential inconsistent treatment of
government obligations across States and municipalities that use
different funding methods for government projects.\1403\
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    \1401\ Many commenters requested that the municipal securities
trading exemption be interpreted to include a broader range of State
and municipal obligations issued by agencies and instrumentalities.
See, e.g., ABA (Keating); Ashurst; BoA; BDA (Feb. 2012); Fixed
Income Forum/Credit Roundtable; Sens. Merkley & Levin (Feb. 2012);
SIFMA (Municipal Securities) (Feb. 2012); Citigroup (Jan. 2012);
Comm. on Capital Markets Regulation.
    \1402\ See, e.g., Citigroup (Jan. 2012); Ashurst; SIFMA et al.
(Prop. Trading) (Feb. 2012); SIFMA (Municipal Securities) (Feb.
2012); Chamber (Dec. 2011); BlackRock; Fixed Income Forum/Credit
Roundtable.
    \1403\ Commenters represented that the proposed rule would
result in inconsistent applications of the exemption across States
and political subdivisions. The Agencies also recognize, as noted by
commenters, that the proposed rule would likely have resulted in a
bifurcation of the municipal securities market and associated
administrative burdens and disruptions. See, e.g., MSRB; Am. Pub.
Power et al.; Port Authority; Citigroup (Jan. 2012); SIFMA et al.
(Prop. Trading) (Feb. 2012); SIFMA (Municipal Securities) (Feb.
2012).
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    The Agencies believe that interpreting the language of section
13(d)(1)(A) of the BHC Act to provide an exemption to the prohibition
on proprietary trading for obligations issued by States and municipal
agencies and instrumentalities as described above is consistent with
the terms and purposes of section 13 of the BHC Act.\1404\ The Agencies
recognize that state and political subdivision agency obligations
generally present the same level of risk as direct obligations of
States and political subdivisions.\1405\ Moreover, the Agencies
recognize that other federal laws and regulations define the term
``political subdivision'' to include municipal agencies and
instrumentalities.\1406\ The Agencies decline to exclude from this
exemption conduit obligations that benefit private entities, as
suggested by some commenters.\1407\
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    \1404\ Commenters asserted that permitting trading in a broader
group of municipal securities would be consistent with the terms and
purposes of section 13. See, e.g., Ashurst; Citigroup (Jan. 2012);
Eaton Vance; Am. Pub. Power et al.; SIFMA (Municipal Securities)
(Feb. 2012).
    \1405\ Commenters argued that obligations issued by agencies and
instrumentalities generally have the same level of risk as direct
obligations of States and political subdivisions. See, e.g., CHFA;
Sens. Merkley & Levin (Feb. 2012); Am. Pub. Power et al.; North
Carolina. In response to one commenter's concern that the markets
for bonds issued by agencies and instrumentalities are not properly
regulated, the Agencies note that all types of municipal securities,
as defined under the securities laws to include, among others, State
direct obligation bonds and agency or instrumentality bonds, are
generally subject to the same regulations under the securities laws.
Thus, the Agencies do not believe that obligations of agencies and
instrumentalities are subject to less effective regulation than
obligations of States and political subdivisions. See Occupy.
    \1406\ Commenters noted that a number of federal statutes and
regulations define ``political subdivision'' to include municipal
agencies and instrumentalities. See, e.g., MSRB; Citigroup (Jan.
2012).
    \1407\ See AFR et al. (Feb. 2012); Occupy. The Agencies do not
believe it is appropriate to exclude conduit obligations, which are
tax-exempt municipal bonds, from this exemption because such
obligations are used to finance important projects related to, for
example, multi-family housing, healthcare (hospitals and nursing
homes), colleges and universities, power and energy companies and
resource recovery facilities. See U.S. Securities & Exchange
Comm'n., Report on the Municipal Securities Market 7 (2012),
available at http://www.sec.gov/news/studies/2012/munireport073112.pdf.
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    The proposal did not exempt proprietary trading of derivatives on
obligations of States and political subdivisions. The proposal