of the requirements in the market-making exemption look to the specific
type(s) of financial instruments in which a market is being made, and
such requirements are designed to take into account differences among
markets and asset classes, the Agencies believe it is important that
these requirements be applied to a discrete and identifiable unit
engaged in, and operated by personnel whose responsibilities relate to,
making a market in a specific set or type of financial instruments.
Further, applying requirements at the trading desk level should
facilitate banking entity monitoring and review of compliance with the
exemption by limiting the aggregate trading volume that must be
reviewed, as well as allowing consideration of the particular facts and
circumstances of the desk's trading activities (e.g., the liquidity,
maturity, and depth of the market for the relevant types of financial
instruments). As discussed above, the Agencies believe that applying
the requirements of the market-making exemption to a higher level of
organization would reduce the ability to consider the liquidity,
maturity, and depth of the market for a type of financial instrument,
would impede effective monitoring and compliance reviews, and would
increase the risk of evasion.

ii. Definitions of ``Financial Exposure'' and ``Market-Maker
Inventory''
    Certain requirements of the proposed market-making exemption
referred to a ``purchase or sale of a [financial instrument].'' \709\
Even though the Agencies did not intend to require a trade-by-trade
review, a significant number of commenters expressed concern that this
language could be read to require compliance with the proposed market-
making exemption on a transaction-by-transaction basis.\710\ In
response to these concerns, the Agencies are modifying the exemption to
clarify the manner in which compliance with certain provisions will be
assessed. In particular, rather than a transaction-by-transaction
focus, the market-making exemption in the final rule focuses on two
related aspects of market-making activity: A trading desk's ``market-
maker inventory'' and its overall ``financial exposure.'' \711\
---------------------------------------------------------------------------

    \709\ See proposed rule Sec.  ----.4(b).
    \710\ Some commenters also contended that language in proposed
Appendix B raised transaction-by-transaction implications. See supra
notes 517 to 524 and accompanying text (discussing commenters'
transaction-by-transaction concerns).
    \711\ The Agencies are not adopting a transaction-by-transaction
approach because the Agencies are concerned that such an approach
would be unduly burdensome or impractical and inconsistent with the
manner in which bona fide market making-related activity is
conducted. Additionally, the Agencies are concerned that the burdens
of such an approach would cause banking entities to significantly
reduce or cease market making-related activities, which would cause
negative market impacts harmful to both investors and issuers, as
well as the financial system generally.
---------------------------------------------------------------------------

    The Agencies are adopting an approach that focuses on both a
trading desk's financial exposure and market-maker inventory in
recognition that market making-related activity is best viewed in a
holistic manner and that, during a single day, a trading desk may
engage in a large number of purchases and sales of financial
instruments. While all these transactions must be conducted in
compliance with the market-making exemption, the Agencies recognize
that they involve financial instruments for which the trading desk acts
as market maker (i.e., by standing ready to purchase and sell that type
of financial instrument) and instruments that are acquired to manage
the risks of positions in financial instruments for which the desk acts
as market maker, but in which the desk is not itself a market
maker.\712\
---------------------------------------------------------------------------

    \712\ See Joint Proposal, 76 FR 68,870 n.146 (``The Agencies
note that a market maker may often make a market in one type of
[financial instrument] and hedge its activities using different
[financial instruments] in which it does not make a market.''); CFTC
Proposal, 77 FR 8356 n.152.
---------------------------------------------------------------------------

    The final rule requires that activity by a trading desk under the
market-making exemption be evaluated by a banking entity through
monitoring and setting limits for the trading desk's market-maker
inventory and financial exposure. The market-maker inventory of a
trading desk includes the positions in financial instruments, including
derivatives, in which the trading desk acts as market maker. The
financial exposure of the trading desk includes the aggregate risks of
financial instruments in the market-maker inventory of the trading desk
plus the financial instruments, including derivatives, that are
acquired to manage the risks of the positions in financial instruments
for which the trading desk acts as a market maker, but in which the
trading desk does not itself make a market, as well as any associated
loans, commodities, and foreign exchange that are acquired as incident
to acting as a market maker. In addition, the trading desk generally
must maintain its market-maker inventory and financial exposure within
its market-maker inventory limit and its financial exposure limit,
respectively and, to the extent that any limit of the trading desk is
exceeded, the trading desk must take action to bring the trading desk
into compliance with the limits as promptly as possible after the limit
is exceeded.\713\ Thus, if market movements cause a trading desk's
financial exposure to exceed one or more of its risk limits, the
trading desk must promptly take action to reduce its financial exposure
or obtain approval for an increase to its limits through the required
escalation procedures, detailed below. A trading desk may not, however,
enter into a trade that would cause it to exceed its limits without
first receiving approval through its escalation procedures.\714\
---------------------------------------------------------------------------

    \713\ See final rule Sec.  ----.4(b)(2)(iv).
    \714\ See final rule Sec.  ----.4(b)(2)(iii)(E).
---------------------------------------------------------------------------

    Under the final rule, the term market-maker inventory is defined to
mean all of the positions, in the financial instruments for which the
trading desk stands ready to make a market in accordance with paragraph
(b)(2)(i) of this section, that are managed by the trading desk,
including the trading desk's open positions or exposures arising from
open transactions.\715\ Those financial instruments in which a trading
desk acts as market maker must be identified in the trading desk's
compliance program under Sec.  ----.4(b)(2)(iii)(A) of the final rule.
As used throughout this SUPPLEMENTARY INFORMATION, the term
``inventory'' refers to both the retention of financial instruments
(e.g., securities) and, in the context of derivatives trading, the risk
exposures arising out of market-making related activities.\716\
Consistent with the statute, the final rule requires that the market-
maker inventory of a trading desk be designed not to exceed, on an
ongoing basis, the reasonably expected near term demands of clients,
customers, or counterparties.
---------------------------------------------------------------------------

    \715\ See final rule Sec.  ----.4(b)(5).
    \716\ As noted in the proposal, certain types of market making-
related activities, such as market making in derivatives, involves
the retention of principal exposures rather than the retention of
actual financial instruments. See Joint Proposal, 76 FR 68,869
n.143; CFTC Proposal, 77 FR 8354 n.149. This type of activity would
be included under the concept of ``inventory'' in the final rule.
---------------------------------------------------------------------------

    The financial exposure concept is broader in scope than market-
maker inventory and reflects the aggregate risks of the financial
instruments (as well as any associated loans, spot commodities, or spot
foreign exchange or currency) the trading desk manages as part of its
market making-related activities.\717\ Thus, a trading desk's financial
exposure will take into account a trading desk's positions in
instruments for which it does not act as a market maker, but which are
established as part of its market making-related activities, which
includes risk mitigation and hedging. For instance, a trading desk that
acts as a market maker in Euro-denominated corporate bonds may, in
addition to Euro-denominated bonds, enter into credit default swap
transactions on individual European corporate bond issuers or an index
of European corporate bond issuers in order to hedge its exposure
arising from its corporate bond inventory, in accordance with its
documented hedging policies and procedures. Though only the corporate
bonds would be considered as part of the trading desk's market-maker
inventory, its overall financial exposure would also include the credit
default swaps used for hedging purposes.
---------------------------------------------------------------------------

    \717\ The Agencies recognize that under the statute a banking
entity's positions in loans, spot commodities, and spot foreign
exchange or currency are not subject to the final rule's
restrictions on proprietary trading. Thus, a banking entity's
trading in these instruments does not need to comply with the
market-making exemption or any other exemption to the prohibition on
proprietary trading. A banking entity may, however, include
exposures in loans, spot commodities, and spot foreign exchange or
currency that are related to the desk's market-making activities in
determining the trading desk's financial exposure and in turn, the
desk' s financial exposure limits under the market-making exemption.
The Agencies believe this will provide a more accurate picture of
the trading desk's financial exposure. For example, a market maker
in foreign exchange forwards or swaps may mitigate the risks of its
market-maker inventory with spot foreign exchange.
---------------------------------------------------------------------------

    As noted above, the Agencies believe the extent to which a trading
desk is engaged in permitted market making-related activities is best
determined by

evaluating both the financial exposure that results from the desk's
trading activity and the amount, types, and risks of the financial
instruments in the desk's market-maker inventory. Both concepts are
independently valuable and will contribute to the effectiveness of the
market-making exemption. Specifically, a trading desk's financial
exposure will highlight the net exposure and risks of its positions
and, along with an analysis of the actions the trading desk will take
to demonstrably reduce or otherwise significantly mitigate promptly the
risks of that exposure consistent with its limits, the extent to which
it is appropriately managing the risk of its market-maker inventory
consistent with applicable limits, all of which are significant to an
analysis of whether a trading desk is engaged in market making-related
activities. An assessment of the amount, types, and risks of the
financial instruments in a trading desk's market-maker inventory will
identify the aggregate amount of the desk's inventory in financial
instruments for which it acts as market maker, the types of these
financial instruments that the desk holds at a particular time, and the
risks arising from such holdings. Importantly, an analysis of a trading
desk's market-maker inventory will inform the extent to which this
inventory is related to the reasonably expected near term demands of
clients, customers, or counterparties.
    Because the market-maker inventory concept is more directly related
to the financial instruments that a trading desk buys and sells from
customers than the financial exposure concept, the Agencies believe
that requiring review and analysis of a trading desk's market-maker
inventory, as well as its financial exposure, will enhance compliance
with the statute's near-term customer demand requirement. While the
amount, types, and risks of a trading desk's market-maker inventory are
constrained by the near-term customer demand requirement, any other
positions in financial instruments managed by the trading desk as part
of its market making-related activities (i.e., those reflected in the
trading desk's financial exposure, but not included in the trading
desk's market-maker inventory) are also constrained because they must
be consistent with the market-maker inventory or, if taken for hedging
purposes, designed to reduce the risks of the trading desk's market-
maker inventory.
    The Agencies note that disaggregating the trading desk's market-
maker inventory from its other exposures also allows for better
identification of the trading desk's hedging positions in instruments
for which the trading desk does not make a market. As a result, a
banking entity's systems should be able to readily identify and monitor
the trading desk's hedging positions that are not in its market-maker
inventory. As discussed in Part IV.A.3.c.3., a trading desk must have
certain inventory and risk limits on its market-maker inventory, the
products, instruments, and exposures the trading desk may use for risk
management purposes, and its financial exposure that are designed to
facilitate the trading desk's compliance with the exemption and that
are based on the nature and amount of the trading desk's market making-
related activities, including analyses regarding the reasonably
expected near term demands of customers.\718\
---------------------------------------------------------------------------

    \718\ See infra Part IV.A.3.c.2.c.; final rule Sec.  --
--.4(b)(2)(iii)(C).
---------------------------------------------------------------------------

    The final rule also requires these policies and procedures to
contain escalation procedures if a trade would exceed the limits set
for the trading desk. However, the final rule does not permit a trading
desk to exceed the limits solely based on customer demand. Rather,
before executing a trade that would exceed the desk's limits or
changing the desk's limits, a trading desk must first follow the
relevant escalation procedures, which may require additional approval
within the banking entity and provide demonstrable analysis that the
basis for any temporary or permanent increase in limits is consistent
with the reasonably expected near term demands of customers.
    Due to these considerations, the Agencies believe the final rule
should result in more efficient compliance analyses on the part of both
banking entities and Agency supervisors and examiners and should be
less costly for banking entities to implement than a transaction-by-
transaction or instrument-by-instrument approach. For example, the
Agencies believe that some banking entities already compute and monitor
most trading desks' financial exposures for risk management or other
purposes.\719\ The Agencies also believe that focusing on the financial
exposure and market-maker inventory of a trading desk, as opposed to
each separate individual transaction, is consistent with the statute's
goal of reducing proprietary trading risk in the banking system and its
exemption for market making-related activities. The Agencies recognize
that banking entities may not currently disaggregate trading desks'
market-maker inventory from their financial exposures and that, to the
extent banking entities do not currently separately identify trading
desks' market-maker inventory, requiring such disaggregation for
purposes of this rule will impose certain costs. In addition, the
Agencies understand that an approach focused solely on the aggregate of
all the unit's trading positions, as suggested by some commenters,
would present fewer burdens.\720\ However, for the reasons discussed
above, the Agencies believe such disaggregation is necessary to give
full effect to the statute's near term customer demand requirement.
---------------------------------------------------------------------------

    \719\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012)
(stating that modern trading units generally view individual
positions as a bundle of characteristics that contribute to their
complete portfolio). See also Federal Reserve Board, Trading and
Capital-Markets Activities Manual Sec.  2000.1 (Feb. 1998) (``The
risk-measurement system should also permit disaggregation of risk by
type and by customer, instrument, or business unit to effectively
support the management and control of risks.'').
    \720\ See ACLI (Feb. 2012); Fixed Income Forum/Credit
Roundtable; SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------

    The Agencies note that whether a financial instrument or exposure
stemming from a derivative is considered to be market-maker inventory
is based only on whether the desk makes a market in the financial
instrument, regardless of the type of counterparty or the purpose of
the transaction. Thus, the Agencies believe that banking entities
should be able to develop a standardized methodology for identifying a
trading desk's positions and exposures in the financial instruments for
which it acts as a market maker. As further discussed in this Part, a
trading desk's financial exposure must reflect the aggregate risks
managed by the trading desk as part of its market making-related
activities,\721\ and a banking entity should be able to demonstrate
that the financial exposure of a trading desk is related to its market-
making activities.
---------------------------------------------------------------------------

    \721\ See final rule Sec.  ----.4(b)(4).
---------------------------------------------------------------------------

    The final rule defines ``financial exposure'' to mean the
``aggregate risks of one or more financial instruments and any
associated loans, commodities, or foreign exchange or currency, held by
a banking entity or its affiliate and managed by a particular trading
desk as part of the trading desk's market making-related activities.''
\722\ In this context, the term ``aggregate'' does not imply that a
long exposure in one instrument can be combined with a short exposure
in a similar or related

instrument to yield a total exposure of zero. Instead, such a
combination may reduce a trading desk's economic exposure to certain
risk factors that are common to both instruments, but it would still
retain any basis risk between those financial instruments or
potentially generate a new risk exposure in the case of purposeful
hedging.
---------------------------------------------------------------------------

    \722\ Final rule Sec.  ----.4(b)(4). For example, in the case of
derivatives, a trading desk's financial position will be the
residual risks of the trading desk's open positions. For instance,
an options desk may have thousands of open trades at any given time,
including hedges, but the desk will manage, among other risk
factors, the trading desk's portfolio delta, gamma, rho, and
volatility.
---------------------------------------------------------------------------

    With respect to the frequency with which a trading desk should
determine its financial exposure and the amount, types, and risks of
the financial instruments in its market-maker inventory, a trading
desk's financial exposure and market-maker inventory should be
evaluated and monitored at a frequency that is appropriate for the
trading desk's trading strategies and the characteristics of the
financial instruments the desk trades, including historical intraday
volatility. For example, a trading desk that repeatedly acquired and
then terminated significant financial exposures throughout the day but
that had little or no financial exposure at the end of the day should
assess its financial exposure based on its intraday activities, not
simply its end-of-day financial exposure. The frequency with which a
trading desk's financial exposure and market-maker inventory will be
monitored and analyzed should be specified in the trading desk's
compliance program.
    A trading desk's financial exposure reflects its aggregate risk
exposures. The types of ``aggregate risks'' identified in the trading
desk's financial exposure should reflect consideration of all
significant market factors relevant to the financial instruments in
which the trading desk acts as market maker or that the desk uses for
risk management purposes pursuant to this exemption, including the
liquidity, maturity, and depth of the market for the relevant types of
financial instruments. Thus, market factors reflected in a trading
desk's financial exposure should include all significant and relevant
factors associated with the products and instruments in which the desk
trades as market maker or for risk management purposes, including basis
risk arising from such positions.\723\ Similarly, an assessment of the
risks of the trading desk's market-maker inventory must reflect
consideration of all significant market factors relevant to the
financial instruments in which the trading desk makes a market.
Importantly, a trading desk's financial exposure and the risks of its
market-maker inventory will change based on the desk's trading activity
(e.g., buying an instrument that it did not previously hold, increasing
its position in an instrument, or decreasing its position in an
instrument) as well as changing market conditions related to
instruments or positions managed by the trading desk.
---------------------------------------------------------------------------

    \723\ As discussed in Part IV.A.3.c.3., a banking entity must
establish, implement, maintain, and enforce policies and procedures,
internal controls, analysis, and independent testing regarding the
financial instruments each trading desk stands ready to purchase and
sell and the products, instruments, or exposures each trading desk
may use for risk management purposes. See final rule Sec.  --
--.4(b)(2)(iii).
---------------------------------------------------------------------------

    Because the final rule defines ``trading desk'' based on
operational functionality rather than corporate formality, a trading
desk's financial exposure may include positions that are booked in
different affiliated legal entities.\724\ The Agencies understand that
positions may be booked in different legal entities for a variety of
reasons, including regulatory reasons. For example, a trading desk that
makes a market in corporate bonds may book its corporate bond positions
in an SEC-registered broker-dealer and may book index CDS positions
acquired for hedging purposes in a CFTC-registered swap dealer. A
financial exposure that reflects both the corporate bond position and
the index CDS position better reflects the economic reality of the
trading desk's risk exposure (i.e., by showing that the risk of the
corporate bond position has been reduced by the index CDS position).
---------------------------------------------------------------------------

    \724\ Other statutory or regulatory requirements, including
those based on prudential safety and soundness concerns, may prevent
or limit a banking entity from booking hedging positions in a legal
entity other than the entity taking the underlying position.
---------------------------------------------------------------------------

    In addition, a trading desk engaged in market making-related
activities in compliance with the final rule may direct another
organizational unit of the banking entity or an affiliate to execute a
risk-mitigating transaction on the trading desk's behalf.\725\ The
other organizational unit may rely on the market-making exemption for
these purposes only if: (i) The other organizational unit acts in
accordance with the trading desk's risk management policies and
procedures established in accordance with Sec.  ----.4(b)(2)(iii) of
the final rule; and (ii) the resulting risk-mitigating position is
attributed to the trading desk's financial exposure (and not the other
organizational unit's financial exposure) and is included in the
trading desk's daily profit and loss calculation. If another
organizational unit of the banking entity or an affiliate establishes a
risk-mitigating position for the trading desk on its own accord (i.e.,
not at the direction of the trading desk) or if the risk-mitigating
position is included in the other organizational unit's financial
exposure or daily profit and loss calculation, then the other
organizational unit must comply with the requirements of the hedging
exemption for such activity.\726\ It may not rely on the market-making
exemption under these circumstances. If a trading desk engages in a
risk-mitigating transaction with a second trading desk of the banking
entity or an affiliate that is also engaged in permissible market
making-related activities, then the risk-mitigating position would be
included in the first trading desk's financial exposure and the contra-
risk would be included in the second trading desk's market-maker
inventory and financial exposure. The Agencies believe the net effect
of the final rule is to allow individual trading desks to efficiently
manage their own hedging and risk mitigation activities on a holistic
basis, while only allowing for external hedging directed by staff
outside of the trading desk under the additional requirements of the
hedging exemption.
---------------------------------------------------------------------------

    \725\ See infra Part IV.A.3.c.4.
    \726\ Under these circumstances, the other organizational unit
would also be required to meet the hedging exemption's documentation
requirement for the risk-mitigating transaction. See final rule
Sec.  ----.5(c).
---------------------------------------------------------------------------

    To include in a trading desk's financial exposure either positions
held at an affiliated legal entity or positions established by another
organizational unit on the trading desk's behalf, a banking entity must
be able to provide supervisors or examiners of any Agency that has
regulatory authority over the banking entity pursuant to section
13(b)(2)(B) of the BHC Act with records, promptly upon request, that
identify any related positions held at an affiliated entity that are
being included in the trading desk's financial exposure for purposes of
the market-making exemption. Similarly, the supervisors and examiners
of any Agency that has supervisory authority over the banking entity
that holds financial instruments that are being included in another
trading desk's financial exposure for purposes of the market-making
exemption must have the same level of access to the records of the
trading desk.\727\ Banking entities should be prepared to provide all
records that identify all positions included in a trading desk's
financial exposure and where such positions are held.
---------------------------------------------------------------------------

    \727\ A banking entity must be able to provide such records when
a related position is held at an affiliate, even if the affiliate
and the banking entity are not subject to the same Agency's
regulatory jurisdiction.

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

    As an example of how a trading desk's market-maker inventory and
financial exposure will be analyzed under the market-making exemption,
assume a trading desk makes a market in a variety of U.S. corporate
bonds and hedges its aggregated positions with a combination of
exposures to corporate bond indexes and specific name CDS in which the
desk does not make a market. To qualify for the market-making
exemption, the trading desk would have to demonstrate, among other
things, that: (i) The desk routinely stands ready to purchase and sell
the U.S. corporate bonds, consistent with the requirement of Sec.  --
--.4(b)(2)(i) of the final rule, and these instruments (or category of
instruments) are identified in the trading desk's compliance program;
(ii) the trading desk's market-maker inventory in U.S. corporate bonds
is designed not to exceed, on an ongoing basis, the reasonably expected
near term demands of clients, customers, or counterparties, consistent
with the analysis and limits established by the banking entity for the
trading desk; (iii) the trading desk's exposures to corporate bond
indexes and single name CDS are designed to mitigate the risk of its
financial exposure, are consistent with the products, instruments, or
exposures and the techniques and strategies that the trading desk may
use to manage its risk effectively (and such use continues to be
effective), and do not exceed the trading desk's limits on the amount,
types, and risks of the products, instruments, and exposures the
trading desk uses for risk management purposes; and (iv) the aggregate
risks of the trading desk's exposures to U.S. corporate bonds,
corporate bond indexes, and single name CDS do not exceed the trading
desk's limits on the level of exposures to relevant risk factors
arising from its financial exposure.
    Our focus on the financial exposure of a trading desk, rather than
a trade-by-trade requirement, is designed to give banking entities the
flexibility to acquire not only market-maker inventory, but positions
that facilitate market making, such as positions that hedge market-
maker inventory.\728\ As commenters pointed out, a trade-by-trade
requirement would view trades in isolation and could fail to recognize
that certain trades that are not customer-facing are nevertheless
integral to market making and financial intermediation.\729\ The
Agencies understand that the risk-reducing effects of combining large
diverse portfolios could, in certain instances, mask otherwise
prohibited proprietary trading.\730\ However, the Agencies do not
believe that taking a transaction-by-transaction approach is necessary
to address this concern. Rather, the Agencies believe that the broader
definitions of ``financial exposure'' and ``market-maker inventory''
coupled with the tailored definition of ``trading desk'' facilitates
the analysis of aggregate risk exposures and positions in a manner best
suited to apply and evaluate the market-making exemption.
---------------------------------------------------------------------------

    \728\ The Agencies believe it is appropriate to apply the
requirements of the exemption to the financial exposure of a
``trading desk,'' rather than the portfolio of a higher level of
organization, for the reasons discussed above, including our concern
that aggregating a large number of disparate positions and exposures
across a range of trading desks could increase the risk of evasion.
See supra Part IV.A.3.c.1.c.i. (discussing the determination to
apply requirements at the trading desk level).
    \729\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012).
    \730\ See, e.g., Occupy.
---------------------------------------------------------------------------

    In short, this approach is designed to mitigate the costs of a
trade-by-trade analysis identified by commenters. The Agencies
recognize, however, that this approach is only effective at achieving
the goals of the section 13 of the BHC Act--promoting financial
intermediation and limiting speculative risks within banking entities--
if there are limits on a trading desk's financial exposure. That is, a
permissive market-making exemption that gives banking entities maximum
discretion in acquiring positions to provide liquidity runs the risk of
also allowing banking entities to engage in speculative trades. As
discussed more fully in the following Parts of this SUPPLEMENTARY
INFORMATION, the final market-making exemption provides a number of
controls on a trading desk's financial exposure. These controls
include, among others, a provision requiring that a trading desk's
market-maker inventory be designed not to exceed, on an ongoing basis,
the reasonably expected near term demands of customers and that any
other financial instruments managed by the trading desk be designed to
mitigate the risk of such desk's market-maker inventory. In addition,
the final market-making exemption requires the trading desk's
compliance program to include appropriate risk and inventory limits
tied to the near term demand requirement, as well as escalation
procedures if a trade would exceed such limits. The compliance program,
which includes internal controls and independent testing, is designed
to prevent instances where transactions not related to providing
financial intermediation services are part of a desk's financial
exposure.
iii. Routinely Standing Ready To Buy and Sell
    The requirement to routinely stand ready to buy and sell a type of
financial instrument in the final rule recognizes that market making-
related activities differ based on the liquidity, maturity, and depth
of the market for the relevant type of financial instrument. For
example, a trading desk acting as a market maker in highly liquid
markets would engage in more regular quoting activity than a market
maker in less liquid markets. Moreover, the Agencies recognize that the
maturity and depth of the market also play a role in determining the
character of a market maker's activity.
    As noted above, the standard of ``routinely'' standing ready to buy
and sell will differ across markets and asset classes based on the
liquidity, maturity, and depth of the market for the type of financial
instrument. For instance, a trading desk that is a market maker in
liquid equity securities generally should engage in very regular or
continuous quoting and trading activities on both sides of the market.
In less liquid markets, a trading desk should engage in regular quoting
activity across the relevant type(s) of financial instruments, although
such quoting may be less frequent than in liquid equity markets.\731\
Consistent with the CFTC's and SEC's interpretation of market making in
swaps and security-based swaps for purposes of the definitions of
``swap dealer'' and ``security-based swap dealer,'' ``routinely'' in
the swap market context means that the trading desk should stand ready
to enter into swaps or security-based swaps at the request or demand of
a counterparty more frequently than occasionally.\732\ The Agencies
note that a trading desk may routinely stand ready to enter into
derivatives on both sides of the market, or it may routinely stand
ready to enter into derivatives on either side of the market and then
enter into one or more offsetting positions in the derivatives market
or another market, particularly in the case of relatively less liquid
derivatives. While a trading desk may respond to requests to trade
certain

products, such as custom swaps, even if it does not normally quote in
the particular product, the trading desk should hedge against the
resulting exposure in accordance with its financial exposure and
hedging limits.\733\ Further, the Agencies continue to recognize that
market makers in highly illiquid markets may trade only intermittently
or at the request of particular customers, which is sometimes referred
to as trading by appointment.\734\ A trading desk's block positioning
activity would also meet the terms of this requirement provided that,
from time to time, the desk engages in block trades (i.e., trades of a
large quantity or with a high dollar value) with customers.\735\
---------------------------------------------------------------------------

    \731\ Indeed, in the most specialized situations, such
quotations may only be provided upon request. See infra note 735 and
accompanying text (discussing permissible block positioning).
    \732\ The Agencies will consider factors similar to those
identified by the CFTC and SEC in connection with this standard. See
Further Definition of ``Swap Dealer,'' ``Security-Based Swap
Dealer,'' ``Major Swap Participant,'' ``Major Security-Based Swap
Participant'' and ``Eligible Contract Participant'', 77 FR 30596,
30609 (May 23, 2012)
    \733\ The Agencies recognize that, as noted by commenters,
preventing a banking entity from conducting customized transactions
with customers may impact customers' risk exposures or transaction
costs. See Goldman (Prop. Trading); SIFMA (Asset Mgmt.) (Feb. 2012).
The Agencies are not prohibiting this activity under the final rule,
as discussed in this Part.
    \734\ The Agencies have considered comments on the issue of
whether trading by appointment should be permitted under the final
market-making exemption. The Agencies believe it is appropriate to
permit trading by appointment to the extent that there is customer
demand for liquidity in the relevant products.
    \735\ As noted in the preamble to the proposed rule, the size of
a block will vary among different asset classes. The Agencies also
stated in the proposal that the SEC's definition of ``qualified
block positioner'' in Rule 3b-8(c) under the Exchange Act may serve
as guidance for determining whether block positioning activity
qualifies for the market-making exemption. In referencing that rule
as guidance, the Agencies did not intend to imply that a banking
entity engaged in block positioning activity would be required to
meet all terms of the ``qualified block positioner'' definition at
all times. Nonetheless, a number of commenters indicated that it was
unclear when a banking entity would need to act as a qualified block
positioner in accordance with Rule 3b-8(c) and expressed concern
that uncertainty could have a chilling effect on a banking entity's
willingness to facilitate customer block trades. See, e.g., RBC;
SIFMA (Asset Mgmt.) (Feb. 2012); Goldman (Prop. Trading). For
example, a few commenters stated that certain requirements in Rule
3b-8(c) could cause fire sales or general market uncertainty. See
id. After considering comments, the Agencies have decided that the
reference to Rule 3b-8(c) is unnecessary for purposes of the final
rule. In particular, the Agencies believe that the requirements in
the market-making exemption provide sufficient safeguards, and the
additional requirements of the ``qualified block positioner''
definition may present unnecessary burdens or redundancies with the
rule, as adopted. For example, the Agencies believe that there is
some overlap between Sec.  ----.4(b)(2)(ii) of the exemption, which
provides that the amount, types, and risks of the financial
instruments in the trading desk's market-maker inventory must be
designed not to exceed the reasonably expected near term demands of
clients, customers, or counterparties, and Rule 3b-8(c)(iii), which
requires the sale of the shares comprising the block as rapidly as
possible commensurate with the circumstances. In other words, the
market-making exemption would require a banking entity to
appropriately manage its inventory when engaged in block positioning
activity, but would not speak directly to the timing element given
the diversity of markets to which the exemption applies.
    As noted above, one commenter analyzed the potential market
impact of a complete restriction on a market maker's ability to
provide direct liquidity to help a customer execute a large block
trade. See supra note 682 and accompanying text. Because the
Agencies are not restricting a banking entity's ability to engage in
block positioning in the manner suggested by this commenter, the
Agencies do not believe that the final rule will cause the cited
market impact of incremental transaction costs between $1.7 and $3.4
billion per year. The Agencies address this commenter's concern
about the impact of inventory metrics on a banking entity's
willingness to engage in block trading in Part IV.C.3. (discussing
the metrics requirement in the final rule and noting that metrics
will not be used to determine compliance with the rule but, rather,
will be monitored for patterns over time to identify activities that
may warrant further review).
    One commenter appeared to request that block trading activity
not be subject to all requirements of the market-making exemption.
See SIFMA (Asset Mgmt.) (Feb. 2012). Any activity conducted in
reliance on the market-making exemption, including block trading
activity, must meet the requirements of the market-making exemption.
The Agencies believe the requirements in the final rule are workable
for block positioning activity and do not believe it would be
appropriate to subject block positioning to lesser requirements than
general market-making activity. For example, trading in large block
sizes can expose a trading desk to greater risk than market making
in smaller sizes, particularly absent risk management requirements.
Thus, the Agencies believe it is important for block positioning
activity to be subject to the same requirements, including the
requirements to establish risk limits and risk management
procedures, as general market-making activity.
---------------------------------------------------------------------------

    Regardless of the liquidity, maturity, and depth of the market for
a particular type of financial instrument, a trading desk should have a
pattern of providing price indications on either side of the market and
a pattern of trading with customers on each side of the market. In
particular, in the case of relatively illiquid derivatives or
structured instruments, it would not be sufficient to demonstrate that
a trading desk on occasion creates a customized instrument or provides
a price quote in response to a customer request. Instead, the trading
desk would need to be able to demonstrate a pattern of taking these
actions in response to demand from multiple customers with respect to
both long and short risk exposures in identified types of instruments.
    This requirement of the final rule applies to a trading desk's
activity in one or more ``types'' of financial instruments.\736\ The
Agencies recognize that, in some markets, such as the corporate bond
market, a market maker may regularly quote a subset of instruments
(generally the more liquid instruments), but may not provide regular
quotes in other related but less liquid instruments that the market
maker is willing and available to trade. Instead, the market maker
would provide a price for those instruments upon request.\737\ The
trading desk's activity, in the aggregate for a particular type of
financial instrument, indicates whether it is engaged in activity that
is consistent with Sec.  ----.4(b)(2)(i) of the final rule.
---------------------------------------------------------------------------

    \736\ This approach is generally consistent with commenters'
requested clarification that a trading desk's quoting activity will
not be assessed on an instrument-by-instrument basis, but rather
across a range of similar instruments for which the trading desk
acts as a market maker. See, e.g., RBC; SIFMA et al. (Prop. Trading)
(Feb. 2012); CIEBA; Goldman (Prop. Trading).
    \737\ See, e.g., Goldman (Prop. Trading); Morgan Stanley; RBC;
SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------

    Notably, this requirement provides that the types of financial
instruments for which the trading desk routinely stands ready to
purchase and sell must be related to its authorized market-maker
inventory and it authorized financial exposure. Thus, the types of
financial instruments for which the desk routinely stands ready to buy
and sell should compose a significant portion of its overall financial
exposure. The only other financial instruments contributing to the
trading desk's overall financial exposure should be those designed to
hedge or mitigate the risk of the financial instruments for which the
trading desk is making a market. It would not be consistent with the
market-making exemption for a trading desk to hold only positions in,
or be exposed to, financial instruments for which the trading desk is
not a market maker.\738\
---------------------------------------------------------------------------

    \738\ The Agencies recognize that there could be limited
circumstances under which a trading desk's financial exposure does
not relate to the types of financial instruments that it is standing
ready to buy and sell for a short period of time. However, the
Agencies would expect for such occurrences to be minimal. For
example, this scenario could occur if a trading desk unwinds a hedge
position after the market-making position has already been unwound
or if a trading desk acquires an anticipatory hedge position prior
to acquiring a market-making position. As discussed more thoroughly
in Part IV.A.3.c.3., a banking entity must establish written
policies and procedures, internal controls, analysis, and
independent testing that establish appropriate parameters around
such activities.
---------------------------------------------------------------------------

    A trading desk's routine presence in the market for a particular
type of financial instrument would not, on its own, be sufficient
grounds for relying on the market-making exemption. This is because the
frequency at which a trading desk is active in a particular market
would not, on its own, distinguish between permitted market making-
related activity and impermissible proprietary trading. In response to
comments, the final rule provides that a trading desk also must be
willing and available to quote, buy and sell, or otherwise enter into
long and short positions in the relevant type(s) of financial
instruments for its

own account in commercially reasonable amounts and throughout market
cycles.\739\ Importantly, a trading desk would not meet the terms of
this requirement if it provides wide quotations relative to prevailing
market conditions and is not engaged in other activity that evidences a
willingness or availability to provide intermediation services.\740\
Under these circumstances, a trading desk would not be standing ready
to purchase and sell because it is not genuinely quoting or trading
with customers.
---------------------------------------------------------------------------

    \739\ See, e.g., Occupy; Better Markets (Feb. 2012).
    \740\ One commenter expressed concern that a banking entity may
be able to rely on the market-making exemption when it is providing
only wide, out of context quotes. See Occupy.
---------------------------------------------------------------------------

    In the context of this requirement, ``commercially reasonable
amounts'' means that the desk generally must be willing to quote and
trade in sizes requested by other market participants.\741\ For trading
desks that engage in block trading, this would include block trades
requested by customers, and this language is not meant to restrict a
trading desk from acting as a block positioner. Further, a trading desk
must act as a market maker on an appropriate basis throughout market
cycles and not only when it is most favorable for it to do so.\742\ For
example, a trading desk should be facilitating customer needs in both
upward and downward moving markets.
---------------------------------------------------------------------------

    \741\ As discussed below, this may include providing quotes in
the interdealer trading market.
    \742\ Algorithmic trading strategies that only trade when market
factors are favorable to the strategy's objectives or that otherwise
frequently exit the market would not be considered to be standing
ready to purchase or sell a type of financial instrument throughout
market cycles and, thus, would not qualify for the market-making
exemption. The Agencies believe this addresses commenters' concerns
about high-frequency trading activities that are only active in the
market when it is believed to be profitable, rather than to
facilitate customers. See, e.g., Better Markets (Feb. 2012). The
Agencies are not, however, prohibiting all high-frequency trading
activities under the final rule or otherwise limiting high-frequency
trading by banking entities by imposing a resting period on their
orders, as requested by certain commenters. See, e.g., Better
Markets (Feb. 2012); Occupy; Public Citizen.
---------------------------------------------------------------------------

    As discussed further in Part IV.A.3.c.3., the financial instruments
the trading desk stands ready to buy and sell must be identified in the
trading desk's compliance program.\743\ Certain requirements in the
final exemption apply to the amount, types, and risks of these
financial instruments that a trading desk can hold in its market-maker
inventory, including the near term customer demand requirement \744\
and the need to have certain risk and inventory limits.\745\
---------------------------------------------------------------------------

    \743\ See final rule Sec.  ----.4(b)(2)(iii)(A).
    \744\ See final rule Sec.  ----.4(b)(2)(ii).
    \745\ See final rule Sec.  ----.4(b)(2)(iii)(C).
---------------------------------------------------------------------------

    In response to the proposed requirement that a trading desk or
other organizational unit hold itself out, some commenters requested
that the Agencies limit the availability of the market-making exemption
to trading in particular asset classes or trading on particular venues
(e.g., organized trading platforms). The Agencies are not limiting the
availability of the market-making exemption in the manner requested by
these commenters.\746\ Provided there is customer demand for liquidity
in a type of financial instrument, the Agencies do not believe the
availability of the market-making exemption should depend on the
liquidity of that type of financial instrument or the ability to trade
such instruments on an organized trading platform. The Agencies see no
basis in the statutory text for either approach and believe that the
likely harms to investors seeking to trade affected instruments (e.g.,
reduced ability to purchase or sell a particular instrument,
potentially higher transaction costs) and market quality (e.g., reduced
liquidity) that would arise under such an approach would not be
justified,\747\ particularly in light of the minimal benefits that
might result from restricting or eliminating a banking entity's ability
to hold less liquid assets in connection with its market making-related
activities. The Agencies believe these commenters' concerns are
adequately addressed by the final rule's requirements in the market-
making exemption that are designed to ensure that a trading desk cannot
hold risk in excess of what is appropriate to provide intermediation
services designed not to exceed, on an ongoing basis, the reasonably
expected near term demands of clients, customers, or counterparties.
---------------------------------------------------------------------------

    \746\ For example, a few commenters requested that the rule
prohibit banking entities from market making in assets classified as
Level 3 under FAS 157. See supra note 651 and accompanying text. The
Agencies continue to believe that it would be inappropriate to
incorporate accounting standards in the rule because accounting
standards could change in the future without consideration of the
potential impact on the final rule. See Joint Proposal, 76 FR 68,859
n.101 (explaining why the Agencies declined to incorporate certain
accounting standards in the proposed rule); CFTC Proposal, 77 FR
8344 n.107.
    Further, a few commenters suggested that the exemption should
only be available for trading on an organized trading facility. This
type of limitation would require significant and widespread market
structure changes (with associated systems and infrastructure costs)
in a relatively short period of time, as market making in certain
assets is primarily or wholly conducted in the OTC market, and
organized trading platforms may not currently exist for these
assets. The Agencies do not believe that the costs of such market
structure changes would be warranted for purposes of this rule.
    \747\ As discussed above, a number of commenters expressed
concern about the potential market impacts of the perceived
restrictions on market making under the proposed rule, particularly
with respect to less liquid markets, such as the corporate bond
market. See, e.g., Prof. Duffie; Wellington; BlackRock; ICI.
---------------------------------------------------------------------------

    In response to comments on the proposed interpretation regarding
anticipatory position-taking,\748\ the Agencies note that the near term
demand requirement in the final rule addresses when a trading desk may
take positions in anticipation of reasonably expected near term
customer demand.\749\ The Agencies believe this approach is generally
consistent with the comments the Agencies received on this issue.\750\
In addition, the Agencies note that modifications to the proposed near
term demand requirement in the final rule also address commenters
concerns on this issue.\751\
---------------------------------------------------------------------------

    \748\ Joint Proposal, 76 FR 68,871 (stating that ``bona fide
market making-related activity may include taking positions in
securities in anticipation of customer demand, so long as any
anticipatory buying or selling activity is reasonable and related to
clear, demonstrable trading interest of clients, customers, or
counterparties''); CFTC Proposal, 77 FR 8356-8357; See also Morgan
Stanley (requesting certain revisions to more closely track the
statute); SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop.
Trading); Chamber (Feb. 2012); Comm. on Capital Markets Regulation;
SIFMA (Asset Mgmt.) (Feb. 2012).
    \749\ See final rule Sec.  ----.4(b)(2)(ii); infra Part
IV.A.3.c.2.c.
    \750\ See BoA; SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman
(Prop. Trading); Morgan Stanley; Chamber (Feb. 2012); Comm. on
Capital Markets Regulation; SIFMA (Asset Mgmt.) (Feb. 2012).
    \751\ For example, some commenters suggested that the final rule
allow market makers to make individualized assessments of
anticipated customer demand, based on their expertise and
experience, and account for differences between liquid and less
liquid markets. See Chamber (Feb. 2012); ISDA (Feb. 2012). The final
rule allows such assessments, based on historical customer demand
and other relevant factors, and recognizes that near term demand may
differ based on the liquidity, maturity, and depth of the market for
a particular type of financial instrument. See infra Part
IV.A.3.c.2.c.iii.
---------------------------------------------------------------------------

2. Near Term Customer Demand Requirement
a. Proposed Near Term Customer Demand Requirement
    Consistent with the statute, the proposed rule required that the
trading desk or other organizational unit's market making-related
activities be, with respect to the financial instrument, designed not
to exceed the reasonably expected near term demands of clients,
customers, or counterparties.\752\ This requirement is intended to
prevent a trading desk from taking a speculative proprietary position
that is unrelated to customer needs as part of the desk's

purported market making-related activities.\753\
---------------------------------------------------------------------------

    \752\ See proposed rule Sec.  ----.4(b)(2)(iii).
    \753\ See Joint Proposal, 76 FR 68,871; CFTC Proposal, 77 FR
8357.
---------------------------------------------------------------------------

    In the proposal, the Agencies stated that a banking entity's
expectations of near term customer demand should generally be based on
the unique customer base of the banking entity's specific market-making
business lines and the near term demand of those customers based on
particular factors, beyond a general expectation of price appreciation.
The Agencies further stated that they would not expect the activities
of a trading desk or other organizational unit to qualify for the
market-making exemption if the trading desk or other organizational
unit is engaged wholly or principally in trading that is not in
response to, or driven by, customer demands, regardless of whether
those activities promote price transparency or liquidity. The proposal
stated that, for example, a trading desk or other organizational unit
of a banking entity that is engaged wholly or principally in arbitrage
trading with non-customers would not meet the terms of the proposed
rule's market-making exemption.\754\
---------------------------------------------------------------------------

    \754\ See id.
---------------------------------------------------------------------------

    With respect to market making in a security that is executed on an
exchange or other organized trading facility, the proposal provided
that a market maker's activities are generally consistent with
reasonably expected near term customer demand when such activities
involve passively providing liquidity by submitting resting orders that
interact with the orders of others in a non-directional or market-
neutral trading strategy and the market maker is registered, if the
exchange or organized trading facility registers market makers. Under
the proposal, activities on an exchange or other organized trading
facility that primarily take liquidity, rather than provide liquidity,
would not qualify for the market-making exemption, even if conducted by
a registered market maker.\755\
---------------------------------------------------------------------------

    \755\ See Joint Proposal, 76 FR 68,871-68,872; CFTC Proposal, 77
FR 8357.
---------------------------------------------------------------------------

b. Comments Regarding the Proposed Near Term Customer Demand
Requirement
    As noted above, the proposed near term customer demand requirement
would implement language found in the statute's market-making
exemption.\756\ Some commenters expressed general support for this
requirement.\757\ For example, these commenters emphasized that the
proposed near term demand requirement is an important component that
restricts disguised position-taking or market making in illiquid
markets.\758\ Several other commenters expressed concern that the
proposed requirement is too restrictive \759\ because, for example, it
may impede a market maker's ability to build or retain inventory \760\
or may impact a market maker's willingness to engage in block
trading.\761\ Comments on particular aspects of this proposed
requirement are discussed below, including the proposed interpretation
of this requirement in the proposal, the requirement's potential impact
on market maker inventory, potential differences in this standard
across asset classes, whether it is possible to predict near term
customer demand, and whether the terms ``client,'' ``customer,'' or
``counterparty'' should be defined for purposes of the exemption.
---------------------------------------------------------------------------

    \756\ See supra Part IV.A.3.c.2.a.
    \757\ See, e.g., Sens. Merkley & Levin (Feb. 2012); Flynn &
Fusselman; Better Markets (Feb. 2012).
    \758\ See Better Markets (Feb. 2012); Sens. Merkley & Levin
(Feb. 2012).
    \759\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);
Chamber (Feb. 2012); T. Rowe Price; SIFMA (Asset Mgmt.) (Feb. 2012);
ACLI (Feb. 2012); MetLife; Comm. on Capital Markets Regulation;
CIEBA; Credit Suisse (Seidel); SSgA (Feb. 2012); IAA (stating that
the proposed requirement is too subjective and would be difficult to
administer in a range of scenarios); Barclays; Prof. Duffie.
    \760\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); T.
Rowe Price; CIEBA; Credit Suisse (Seidel); Barclays; Wellington;
MetLife; Chamber (Feb. 2012); RBC; Prof. Duffie; ICI (Feb. 2012);
SIFMA (Asset Mgmt.) (Feb. 2012). The Agencies respond to these
comments in Part IV.A.3.c.2.c., infra. For a discussion of comments
regarding inventory management activity conducted in connection with
market making, See Part IV.A.3.c.2.b.vi., infra.
    \761\ See, e.g., ACLI (Feb. 2012); MetLife; Comm. on Capital
Markets Regulation (noting that a market maker may need to hold
significant inventory to accommodate potential block trade
requests). Two of these commenters stated that a market maker may
provide a worse price or may be unwilling to intermediate a large
customer position if the market maker has to determine whether
holding such position will meet the near term demand requirement,
particularly if the market maker would be required to sell the block
position over a short period of time. See ACLI (Feb. 2012); MetLife.
These comments are addressed in Part IV.A.3.c.2.c.iii., infra.
---------------------------------------------------------------------------

i. The Proposed Guidance for Determining Compliance With the Near Term
Customer Demand Requirement
    As discussed in more detail above, the proposal set forth proposed
guidance on how a banking entity may comply with the proposed near term
customer demand requirement.\762\ With respect to the language
indicating that a banking entity's determination of near term customer
demand should generally be based on the unique customer base of a
specific market-making business line (and not merely an expectation of
future price appreciation), one commenter stated that it is unclear how
a banking entity would be able to make such determinations in markets
where trades occur infrequently and customer demand is hard to
predict.\763\
---------------------------------------------------------------------------

    \762\ See supra Part IV.A.3.c.2.a.
    \763\ See SIFMA et al. (Prop. Trading) (Feb. 2012). Another
commenter suggested that the Agencies ``establish clear criteria
that reflect appropriate revenue from changes in the bid-ask
spread,'' noting that a legitimate market maker should be both
selling and buying in a rising market (or, likewise, in a declining
market). Public Citizen.
---------------------------------------------------------------------------

    Several commenters expressed concern about the proposal's statement
that a trading desk or other organizational unit engaged wholly or
principally in trading that is not in response to, or driven by,
customer demands (e.g., arbitrage trading with non-customers) would not
qualify for the exemption, regardless of whether the activities promote
price transparency or liquidity.\764\ In particular, commenters stated
that it would be difficult for a market-making business to try to
divide its activities that are in response to customer demand (e.g.,
customer intermediation and hedging) from activities that promote price
transparency and liquidity (e.g., interdealer trading to test market
depth or arbitrage trading) in order to determine their
proportionality.\765\ Another commenter stated that, as a matter of
organizational efficiency, firms will often restrict arbitrage trading
strategies to certain specific individual traders within the market-
making organization, who may sometimes be referred to as a ``desk,''
and expressed concern that this would be prohibited under the
rule.\766\
---------------------------------------------------------------------------

    \764\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);
Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); BoA; ICI
(Feb. 2012); ICI Global; Vanguard; SSgA (Feb. 2012); See also infra
Part IV.A.3.c.2.b.viii. (discussing comments on whether arbitrage
trading should be permitted under the market-making exemption under
certain circumstances).
    \765\ See Goldman (Prop. Trading); RBC. One of these commenters
agreed, however, that a trading desk that is ``wholly'' engaged in
trading that is unrelated to customer demand should not qualify for
the proposed market-making exemption. See Goldman (Prop. Trading).
    \766\ See JPMC.
---------------------------------------------------------------------------

    In response to the proposed interpretation regarding market making
on an exchange or other organized trading facility (and certain similar
language in proposed Appendix B),\767\ several commenters indicated
that the reference to passive submission of resting orders may be too
restrictive and provided examples of scenarios where market makers may
need to use market or marketable limit orders.\768\ For

example, many of these commenters stated that market makers may need to
enter market or marketable limit orders to: (i) build or reduce
inventory; \769\ (ii) address order imbalances on an exchange by, for
example, using market orders to lessen volatility and restore pricing
equilibrium; (iii) hedge market-making positions; (iv) create markets;
\770\ (v) test the depth of the markets; (vi) ensure that ETFs,
American depositary receipts (``ADRs''), options, and other instruments
remain appropriately priced; \771\ and (vii) respond to movements in
prices in the markets.\772\ Two commenters noted that distinctions
between limit and market or marketable limit orders may not be workable
in the international context, where exchanges may not use the same
order types as U.S. trading facilities.\773\
---------------------------------------------------------------------------

    \767\ See Joint Proposal, 76 FR 68,871-68,872; CFTC Proposal, 77
FR 8357.
    \768\ See, e.g., NYSE Euronext; SIFMA et al. (Prop. Trading)
(Feb. 2012); Goldman (Prop. Trading); RBC. Comments on proposed
Appendix B are discussed further in Part IV.A.3.c.8.b., infra. This
issue is addressed in note 939 and its accompanying text, infra.
    \769\ Some commenters stated that market makers may need to use
market or marketable limit orders to build inventory in anticipation
of customer demand or in connection with positioning a block trade
for a customer. See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC;
Goldman (Prop. Trading). Two of these commenters noted that these
order types may be needed to dispose of positions taken into
inventory as part of market making. See RBC; Goldman (Prop.
Trading).
    \770\ See NYSE Euronext.
    \771\ See Goldman (Prop. Trading).
    \772\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \773\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman
(Prop. Trading).
---------------------------------------------------------------------------

    A few commenters also addressed the proposed use of a market
maker's exchange registration status as part of the analysis.\774\ Two
commenters stated that the proposed rule should not require a market
maker to be registered with an exchange to qualify for the proposed
market-making exemption. According to these commenters, there are a
large number of exchanges and organized trading facilities on which
market makers may need to trade to maintain liquidity across the
markets and to provide customers with favorable prices. These
commenters indicated that any restrictions or burdens on such trading
may decrease liquidity or make it harder to provide customers with the
best price for their trade.\775\ One commenter, however, stated that
the exchange registration requirement is reasonable and further
supported adding a requirement that traders demonstrate adherence to
the same or commensurate standards in markets where registration is not
possible.\776\
---------------------------------------------------------------------------

    \774\ See NYSE Euronext; SIFMA et al. (Prop. Trading) (Feb.
2012); Goldman (Prop. Trading); Occupy. See also infra notes 940 to
941 and accompanying text (addressing these comments).
    \775\ See SIFMA et al. (Prop. Trading) (Feb. 2012) (stating that
trading units may currently register as market makers with
particular, primary exchanges on which they trade, but will serve in
a market-making capacity on other trading venues from time to time);
Goldman (Prop. Trading) (noting that there are more than 12
exchanges and 40 alternative trading systems currently trading U.S.
equities).
    \776\ See Occupy. In the alternative, this commenter would
require all market making to be performed on an exchange or
organized trading facility. See id.
---------------------------------------------------------------------------

    Some commenters recommended certain modifications to the proposed
analysis. For example, a few commenters requested that the rule presume
that a trading unit is engaged in permitted market making-related
activity if it is registered as a market maker on a particular exchange
or organized trading facility.\777\ In support of this recommendation,
one commenter represented that it would be warranted because registered
market makers directly contribute to maintaining liquid and orderly
markets and are subject to extensive regulatory requirements in that
capacity.\778\ Another commenter suggested that the Agencies instead
use metrics to compare, in the aggregate and over time, the liquidity
that a market maker makes rather than takes as part of a broader
consideration of the market-making character of the relevant trading
activity.\779\
---------------------------------------------------------------------------

    \777\ See NYSE Euronext (recognizing that registration status is
not necessarily conclusive of engaging in market making-related
activities); SIFMA et al. (Prop. Trading) (Feb. 2012) (stating that
to the extent a trading unit is registered on a particular exchange
or organized trading facility for any type of financial instrument,
all of its activities on that exchange or organized trading facility
should be presumed to be market making); Goldman (Prop. Trading).
See also infra note 940 (responding to these comments). Two
commenters noted that certain exchange rules may require market
makers to deal for their own account under certain circumstances in
order to maintain fair and orderly markets. See NYSE Euronext
(discussing NYSE rules); Goldman (Prop. Trading) (discussing NYSE
and CBOE rules). For example, according to these commenters, NYSE
Rule 104(f)(ii) requires a market maker to maintain fair and orderly
markets, which may involve dealing for their own account when there
is a lack of price continuity, lack of depth, or if a disparity
between supply and demand exists or is reasonably anticipated. See
id.
    \778\ See Goldman (Prop. Trading). This commenter further stated
that trading activities of exchange market makers may be
particularly difficult to evaluate with customer-facing metrics
(because ``specialist'' market makers may not have ``customers''),
so conferring a positive presumption of compliance on such market
makers would ensure that they can continue to contribute to
liquidity, which benefits customers. This commenter noted that, for
example, NYSE designated market makers (``DMMs'') are generally
prohibited from dealing with customers and companies must ``wall
off'' any trading units that act as DMMs. See id. (citing NYSE Rule
98).
    \779\ See id. (stating that spread-related metrics, such as
Spread Profit and Loss, may be useful for this purpose).
---------------------------------------------------------------------------

ii. Potential Inventory Restrictions and Differences Across Asset
Classes
    A number of commenters expressed concern that the proposed
requirement may unduly restrict a market maker's ability to manage its
inventory.\780\ Several of these commenters stated that limitations on
inventory would be especially problematic for market making in less
liquid markets, like the fixed-income market, where customer demand is
more intermittent and positions may need to be held for a longer period
of time.\781\ Some commenters stated that the Agencies' proposed
interpretation of this requirement would restrict a market maker's
inventory in a manner that is inconsistent with the statute. These
commenters indicated that the ``designed'' and ``reasonably expected''
language of the statute seem to recognize that market makers must
anticipate customer requests and accumulate sufficient inventory to
meet those reasonably expected demands.\782\ In addition, one commenter
represented that a market maker must have wide latitude and incentives
for initiating trades, rather than merely reacting to customer requests
for quotes, to properly risk manage its positions or to prepare for
anticipated customer demand or supply.\783\ Many commenters requested
certain modifications to the proposed requirement to limit its impact
on market maker inventory.\784\

Commenters' views on the importance of permitting inventory management
activity in connection with market making are discussed below in Part
IV.A.3.c.2.b.vi.
---------------------------------------------------------------------------

    \780\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); T.
Rowe Price; CIEBA; Credit Suisse (Seidel); Barclays; Wellington;
MetLife; Chamber (Feb. 2012); RBC; Prof. Duffie; ICI (Feb. 2012);
SIFMA (Asset Mgmt.) (Feb. 2012). These concerns are addressed in
Part IV.A.3.c.2.c., infra.
    \781\ See, e.g., SIFMA (Asset Mgmt.) (Feb. 2012); T. Rowe Price;
CIEBA; ICI (Feb. 2012); RBC.
    \782\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);
Chamber (Feb. 2012).
    \783\ See Prof. Duffie. However, another commenter stated that a
legitimate market maker should respond to customer demand rather
than initiate transactions, which is indicative of prohibited
proprietary trading. See Public Citizen.
    \784\ See Credit Suisse (Seidel) (suggesting that the rule allow
market makers to build inventory in products where they believe
customer demand will exist, regardless of whether the inventory can
be tied to a particular customer in the near term or to historical
trends in customer demand); Barclays (recommending the rule require
that ``the market making-related activity is conducted by each
trading unit such that its activities (including the maintenance of
inventory) are designed not to exceed the reasonably expected near
term demands of clients, customers, or counterparties consistent
with the market and trading patterns of the relevant product, and
consistent with the reasonable judgment of the banking entity where
such demand cannot be determined with reasonable accuracy''); CIEBA.
In addition, some commenters suggested an interpretation that would
provide greater discretion to market makers to enter into trades
based on factors such as experience and expertise dealing in the
market and market exigencies. See SIFMA et al. (Prop. Trading) (Feb.
2012); Chamber (Feb. 2012). Two commenters suggested that the
proposed requirement should be interpreted to permit market-making
activity as it currently exists. See MetLife; ACLI (Feb. 2012). One
commenter requested that the proposed requirement be moved to
Appendix B of the rule to provide greater flexibility to consider
facts and circumstances of a particular activity. See JPMC.
---------------------------------------------------------------------------

    Several commenters requested that the Agencies recognize that near
term customer demand may vary across different markets and asset
classes and implement this requirement flexibly.\785\ In particular,
many of these commenters emphasized that the concept of ``near term
demand'' should be different for less liquid markets, where
transactions may occur infrequently, and for liquid markets, where
transactions occur more often.\786\ One commenter requested that the
Agencies add the phrase ``based on the characteristics of the relevant
market and asset class'' to the end of the requirement to explicitly
acknowledge these differences.\787\
---------------------------------------------------------------------------

    \785\ See CIEBA; Morgan Stanley; RBC; ICI (Feb. 2012); ISDA
(Feb. 2012); Comm. on Capital Markets Regulation; Alfred Brock. The
Agencies respond to these comments in Part IV.A.3.c.2.c.ii., infra.
    \786\ See ICI (Feb. 2012); CIEBA (stating that, absent a
different interpretation for illiquid instruments, market makers
will err on the side of holding less inventory to avoid sanctions
for violating the rule); RBC.
    \787\ See Morgan Stanley.
---------------------------------------------------------------------------

iii. Predicting Near Term Customer Demand
    Commenters provided views on whether and, if so how, a banking
entity may be able to predict near term customer demand for purposes of
the proposed requirement.\788\ For example, two commenters suggested
ways in which a banking entity could predict near term customer
demand.\789\ One of these commenters indicated that banking entities
should be able to utilize current risk management tools to predict near
term customer demand, although these tools may need to be adapted to
comply with the rule's requirements. According to this commenter,
dealers commonly assess the following factors across product lines,
which can relate to expected customer demand: (i) Recent volumes and
customer trends; (ii) trading patterns of specific customers; (iii)
analysis of whether the firm has an ability to win new customer
business; (iv) comparison of the current market conditions to prior
similar periods; (v) liquidity of large investors; and (vi) the
schedule of maturities in customers' existing positions.\790\ Another
commenter stated that the reasonableness of a market maker's inventory
can be measured by looking to the specifics of the particular market,
the size of the customer base being served, and expected customer
demand, which banking entities should be required to take into account
in both their inventory practices and policies and their actual
inventories. This commenter recommended that the rule permit a banking
entity to assume a position under the market-making exemption if it can
demonstrate a track record or reasonable expectation that it can
dispose of a position in the near term.\791\
---------------------------------------------------------------------------

    \788\ See Wellington; MetLife; SIFMA et al. (Prop. Trading)
(Feb. 2012); Sens. Merkley & Levin (Feb. 2012); Chamber (Feb. 2012);
FTN; RBC; Alfred Brock. These comments are addressed in Part
IV.A.3.c.2.c.iii., infra.
    \789\ See Sens. Merkley & Levin (Feb. 2012); FTN.
    \790\ See FTN. The commenter further indicated that errors in
estimating customer demand are managed through kick-out rules and
oversight by risk managers and committees, with latitude in
decisions being closely related to expected or empirical costs of
hedging positions until they result in trading with counterparties.
See id.
    \791\ See Sens. Merkley & Levin (Feb. 2012) (stating that
banking entities should be required to collect inventory data,
evaluate the data, develop policies on how to handle particular
positions, and make regular adjustments to ensure a turnover of
assets commensurate with near term demand of customers). This
commenter also suggested that the rule specify the types of
inventory metrics that should be collected and suggested that the
rate of inventory turnover would be helpful. See id.
---------------------------------------------------------------------------

    Some commenters, however, emphasized that reasonably expected near
term customer demand cannot always be accurately predicted.\792\
Several of these commenters requested the Agencies clarify that banking
entities will not be subject to regulatory sanctions if reasonably
anticipated near term customer demand does not materialize.\793\ One
commenter further noted that a banking entity entering a new market, or
gaining or losing customers, may need greater flexibility in applying
the near term demand requirement because its anticipated demand may
fluctuate.\794\
---------------------------------------------------------------------------

    \792\ See MetLife; Chamber (Feb. 2012); RBC; CIEBA; Wellington;
ICI (Feb. 2012); Alfred Brock. This issue is addressed in Part
IV.A.3.c.2.c.iii., infra.
    \793\ See ICI (Feb. 2012); CIEBA; RBC; Wellington; Invesco.
    \794\ See CIEBA.
---------------------------------------------------------------------------

iv. Potential Definitions of ``Client,'' ``Customer,'' or
``Counterparty''
    Appendix B of the proposal discussed the proposed meaning of the
term ``customer'' in the context of permitted market making-related
activity.\795\ In addition, the proposal inquired whether the terms
``client,'' ``customer,'' or ``counterparty'' should be defined in the
rule for purposes of the market-making exemption.\796\ Commenters
expressed varying views on the proposed interpretations in the proposal
and on whether these terms should be defined in the final rule.\797\
---------------------------------------------------------------------------

    \795\ See Joint Proposal, 76 FR 68,960; CFTC Proposal, 77 FR
8439. More specifically, Appendix B stated: ``In the context of
market making in a security that is executed on an organized trading
facility or an exchange, a `customer' is any person on behalf of
whom a buy or sell order has been submitted by a broker-dealer or
any other market participant. In the context of market making in a
[financial instrument] in an OTC market, a `customer' generally
would be a market participant that makes use of the market maker's
intermediation services, either by requesting such services or
entering into a continuing relationship with the market maker with
respect to such services.'' Id. On this last point, the proposal
elaborated that in certain cases, depending on the conventions of
the relevant market (e.g., the OTC derivatives market), such a
``customer'' may consider itself or refer to itself more generally
as a ``counterparty.'' See Joint Proposal, 76 FR 68,960 n.2; CFTC
Proposal, 77 FR 8439 n.2.
    \796\ See Joint Proposal, 76 FR 68,874; CFTC Proposal, 77 FR
8359. In particular, Question 99 states: ``Should the terms
`client,' `customer,' or `counterparty' be defined for purposes of
the market making exemption? If so, how should these terms be
defined? For example, would an appropriate definition of `customer'
be: (i) A continuing relationship in which the banking entity
provides one or more financial products or services prior to the
time of the transaction; (ii) a direct and substantive relationship
between the banking entity and a prospective customer prior to the
transaction; (iii) a relationship initiated by the banking entity to
a prospective customer to induce transactions; or (iv) a
relationship initiated by the prospective customer with a view to
engaging in transactions?'' Id.
    \797\ Comments on this issue are addressed in Part
IV.A.3.c.2.c.i., infra.
---------------------------------------------------------------------------

    With respect to the proposed interpretations of the term
``customer'' in Appendix B, one commenter agreed with the proposed
interpretations and expressed the belief that the interpretations will
allow interdealer market making where brokers or other dealers act as
customers. However, this commenter also requested that the Agencies
expressly incorporate providing liquidity to other brokers and dealers
into the rule text.\798\ Another commenter similarly stated that
instead of focusing solely on customer demand, the rule should be
clarified to reflect that demand can come from other dealers or future
customers.\799\
---------------------------------------------------------------------------

    \798\ See SIFMA et al. (Prop. Trading) (Feb. 2012). See also
Credit Suisse (Seidel); RBC (requesting that the Agencies recognize
``wholesale'' market making as permissible and representing that
``[i]t is irrelevant to an investor whether market liquidity is
provided by a broker-dealer with whom the investor maintains a
customer account, or whether that broker-dealer looks to another
dealer for market liquidity'').
    \799\ See Comm. on Capital Markets Regulation.
---------------------------------------------------------------------------

    In response to the proposal's question about whether the terms
``client,'' ``customer,'' and ``counterparty'' should be further
defined, a few commenters stated that that the terms should not be
defined in the rule.\800\ Other

commenters indicated that further definition of these terms would be
appropriate.\801\ Some of these commenters suggested that there should
be greater limitations on who can be considered a ``customer'' under
the rule.\802\ These commenters generally indicated that a ``customer''
should be a person or institution with whom the banking entity has a
continuing, or a direct and substantive, relationship prior to the time
of the transaction.\803\ In the case of a new customer, some of these
commenters suggested requiring a relationship initiated by the
prospective customer with a view to engaging in transactions.\804\ A
few commenters indicated that a party should not be considered a
client, customer, or counterparty if the banking entity: (i) originates
a financial product and then finds a counterparty to take the other
side of the transaction; \805\ or (ii) engages in transactions driven
by algorithmic trading strategies.\806\ Three commenters requested more
permissive definitions of these terms.\807\ According to one of these
commenters, because these terms are listed in the disjunctive in the
statute, the broadest term--a ``counterparty''--should prevail.\808\
---------------------------------------------------------------------------

    \800\ See FTN; ISDA (Feb. 2012); Alfred Brock.
    \801\ See Japanese Bankers Ass'n.; Credit Suisse (Seidel);
Occupy; AFR et al. (Feb. 2012); Public Citizen.
    \802\ See AFR et al. (Feb. 2012); Occupy; Public Citizen. One of
these commenters also requested that the Agencies remove the terms
``client'' and ``counterparty'' from the proposed near term demand
requirement. See Occupy.
    \803\ See AFR et al. (Feb. 2012); Occupy; Public Citizen. These
commenters stated that other banking entities should never be
``customers'' under the rule. See id. In addition, one of these
commenters would further prevent a banking entity's employees and
covered funds from being ``customers'' under the rule. See AFR et
al. (Feb. 2012).
    \804\ See AFR et al. (Feb. 2012) (providing a similar definition
for the term ``client'' as well); Public Citizen.
    \805\ See AFR et al. (Feb. 2012); Public Citizen. See also Sens.
Merkley & Levin (Feb. 2012) (stating that a banking entity's
activities that involve attempting to sell clients financial
instruments that it originated, rather than facilitating a secondary
market for client trades in previously existing financial products,
should be analyzed under the underwriting exemption, not the market-
making exemption; in addition, compiling inventory of financial
instruments that the bank originated should be viewed as proprietary
trading).
    \806\ See AFR et al. (Feb. 2012).
    \807\ See Credit Suisse (Seidel) (stating that ``customer''
should be explicitly defined to include any counterparty to whom a
banking entity is providing liquidity); ISDA (Feb. 2012)
(recommending that, if the Agencies decide to define these terms, a
``counterparty'' should be defined as the entity on the other side
of a transaction, and the terms ``client'' and ``customer'' should
not be interpreted to require a relationship beyond the isolated
provision of a transaction); Japanese Bankers Ass'n. (requesting
that it be clearly noted that interbank participants can be
customers for interbank market makers).
    \808\ See ISDA (Feb. 2012). This commenter's primary position
was that further definitions are not required and could create
additional and unnecessary complexity. See id.
---------------------------------------------------------------------------

v. Interdealer Trading and Trading for Price Discovery or To Test
Market Depth
    With respect to interdealer trading, many commenters expressed
concern that the proposed rule could be interpreted to restrict a
market maker's ability to engage in interdealer trading.\809\ As a
general matter, commenters attributed these concerns to statements in
proposed Appendix B \810\ or to the Customer-Facing Trade Ratio metric
in proposed Appendix A.\811\ A number of commenters requested that the
rule be modified to clearly recognize interdealer trading as a
component of permitted market making-related activity \812\ and
suggested ways in which this could be accomplished (e.g., through a
definition of ``customer'' or ``counterparty'').\813\
---------------------------------------------------------------------------

    \809\ See, e.g., JPMC; Morgan Stanley; Goldman (Prop. Trading);
Chamber (Feb. 2012); MetLife; Credit Suisse (Seidel); BoA; ACLI
(Feb. 2012); RBC; AFR et al. (Feb. 2012); ISDA (Feb. 2012); Oliver
Wyman (Dec. 2011); Oliver Wyman (Feb. 2012). A few commenters noted
that the proposed rule would permit a certain amount of interdealer
trading. See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012) (citing
statements in the proposal providing that a market maker's
``customers'' vary depending on the asset class and market in which
intermediation services are provided and interpreting such
statements as allowing interdealer market making where brokers or
other dealers act as ``customers'' within the proposed construct);
Goldman (Prop. Trading) (stating that interdealer trading related to
hedging or exiting a customer position would be permitted, but
expressing concern that requiring each banking entity to justify
each of its interdealer trades as being related to one of its own
customers would be burdensome and would reduce the effectiveness of
the interdealer market). Commenters' concerns regarding interdealer
trading are addressed in Part IV.A.3.c.2.c.i., infra.
    \810\ See infra Part IV.A.3.c.8.
    \811\ See, e.g., JPMC; SIFMA et al. (Prop. Trading) (Feb. 2012);
Oliver Wyman (Feb. 2012) (recognizing that the proposed rule did not
include specific limits on interdealer trading, but expressing
concern that explicit or implicit limits could be established by
supervisors during or after the conformance period).
    \812\ See MetLife; SIFMA et al. (Prop. Trading) (Feb. 2012);
RBC; Credit Suisse (Seidel); JPMC; BoA; ACLI (Feb. 2012); AFR et al.
(Feb. 2012); ISDA (Feb. 2012); Goldman (Prop. Trading); Oliver Wyman
(Feb. 2012).
    \813\ See RBC (suggesting that explicitly incorporating
liquidity provision to other brokers and dealers in the market-
making exemption would be consistent with the statute's reference to
meeting the needs of ``counterparties,'' in addition to the needs of
clients and customers); AFR et al. (Feb. 2012) (recognizing that the
ability to manage inventory through interdealer transactions should
be accommodated in the rule, but recommending that this activity be
conditioned on a market maker having an appropriate level of
inventory after an interdealer transaction); Goldman (Prop. Trading)
(representing that the Agencies could evaluate and monitor the
amount of interdealer trading that is consistent with a particular
trading unit's market making-related or hedging activity through the
customer-facing activity category of metrics); Oliver Wyman (Feb.
2012) (recommending removal or modification of any metrics or
principles that would indicate that interdealer trading is not
permitted).
---------------------------------------------------------------------------

    Commenters emphasized that interdealer trading provides certain
market benefits, including increased market liquidity; \814\ more
efficient matching of customer order flow; \815\ greater hedging
options to reduce risks; \816\ enhanced ability to accumulate inventory
for current or near term customer demand, work down concentrated
positions arising from a customer trade, or otherwise exit a position
acquired from a customer; \817\ and general price discovery among
dealers.\818\ Regarding the impact of interdealer trading on a market
maker's ability to intermediate customer needs, one commenter studied
the potential impact of interdealer trading limits--in combination with
inventory limits--on trading in the U.S. corporate bond market.
According to this commenter, if interdealer trading had been prohibited
and a market maker's inventory had been limited to the average daily
volume of the market as a whole, 69 percent of customer trades would
have been prevented.\819\ Some commenters stated that a banking entity
would be less able or willing to provide market-making services to
customers if it could not engage in interdealer trading.\820\
---------------------------------------------------------------------------

    \814\ See Prof. Duffie; MetLife; ACLI (Feb. 2012); BDA (Feb.
2012).
    \815\ See Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012);
MetLife; ACLI (Feb. 2012). See also Thakor Study (stating that, when
a market maker provides immediacy to a customer, it relies on being
able to unwind its positions at opportune times by trading with
other market makers, who may have knowledge about impending orders
form their own customers that may induce them to trade with the
market maker).
    \816\ See MetLife; ACLI (Feb. 2012); Goldman (Prop. Trading);
Morgan Stanley; Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012).
    \817\ See Goldman (Prop. Trading); Chamber (Feb. 2012). See also
Prof. Duffie (stating that a market maker acquiring a position from
a customer may wish to rebalance its inventory relatively quickly
through the interdealer network, which is often more efficient than
requesting immediacy from another customer or waiting for another
customer who wants to take the opposite side of the trade).
    \818\ See Chamber (Feb. 2012); Goldman (Prop. Trading).
    \819\ See Oliver Wyman (Feb. 2012) (basing its finding on data
from 2009). This commenter also represented that the natural level
of interdealer volume in the U.S. corporate bond market made up 16
percent of total trading volume in 2010. See id.
    \820\ See Goldman (Prop. Trading); Morgan Stanley. See also BDA
(Feb. 2012) (stating that if dealers in the fixed-income market are
not able to trade with other dealers to ``cooperate with each other
to provide adequate liquidity to the market as a whole,'' an
essential source of liquidity will be eliminated from the market and
existing values of fixed income securities will decline and become
volatile, harming both investors who currently hold such positions
and issuers, who will experience increased interest costs).

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

    As noted above, a few commenters stated that market makers may use
interdealer trading for price discovery purposes.\821\ Some commenters
separately discussed the importance of this activity and requested
that, when conducted in connection with market-making activity, trading
for price discovery be considered permitted market making-related
activity under the rule.\822\ Commenters indicated that price
discovery-related trading results in certain market benefits, including
enhancing the accuracy of prices for customers,\823\ increasing price
efficiency, preventing market instability,\824\ improving market
liquidity, and reducing overall costs for market participants.\825\ As
a converse, one of these commenters stated that restrictions on such
activity could result in market makers setting their prices too high,
exposing them to significant risk and causing a reduction of market-
making activity or widening of spreads to offset the risk.\826\ One
commenter further requested that trading to test market depth likewise
be permitted under the market-making exemption.\827\ This commenter
represented that the Agencies would be able to evaluate the extent to
which trading for price discovery and market depth are consistent with
market making-related activities for a particular market through a
combination of customer-facing activity metrics, including the
Inventory Risk Turnover metric, and knowledge of a banking entity's
trading business developed by regulators as part of the supervisory
process.\828\
---------------------------------------------------------------------------

    \821\ See Chamber (Feb. 2012); Goldman (Prop. Trading).
    \822\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Chamber
(Feb. 2012); Goldman (Prop. Trading). One commenter provided the
following example of such activity: If Security A and Security B
have some price correlation but neither trades regularly, then a
trader may execute a trade in Security A for price discovery
purposes, using the price of Security A to make an informed bid-ask
market to a customer in Security B. See SIFMA et al. (Prop. Trading)
(Feb. 2012).
    \823\ See Goldman (Prop. Trading); Chamber (Feb. 2012) (stating
that this type of trading is necessary in more illiquid markets);
SIFMA et al. (Prop. Trading) (Feb. 2012).
    \824\ See Goldman (Prop. Trading).
    \825\ See Chamber (Feb. 2012).
    \826\ See id.
    \827\ See Goldman (Prop. Trading). This commenter represented
that market makers often make trades with other dealers to test the
depth of the markets at particular price points and to understand
where supply and demand exist (although such trading is not
conducted exclusively with other dealers). This commenter stated
that testing the depth of the market is necessary to provide
accurate prices to customers, particularly when customers Seeks to
enter trades in amounts larger than the amounts offered by dealers
who have sent indications to inter-dealer brokers. See id.
    \828\ See id.
---------------------------------------------------------------------------

vi. Inventory Management
    Several commenters requested that the rule provide banking entities
with greater discretion to manage their inventories in connection with
market making-related activity, including acquiring or disposing of
positions in anticipation of customer demand.\829\ Commenters
represented that market makers need to be able to build, manage, and
maintain inventories to facilitate customer demand. These commenters
further stated that the rule needs to provide some degree of
flexibility for inventory management activities, as inventory needs may
differ based on market conditions or the characteristics of a
particular instrument.\830\ A few commenters cited legislative history
in support of allowing banking entities to hold and manage inventory in
connection with market making-related activities.\831\ Several
commenters noted benefits that are associated with a market maker's
ability to appropriately manage its inventory, including being able to
meet reasonably anticipated future client, customer, or counterparty
demand; \832\ accommodating customer transactions more quickly and at
favorable prices; reducing near term price volatility (in the case of
selling a customer block position); \833\ helping maintain an orderly
market and provide the best price to customers (in the case of
accumulating long or short positions in anticipation of a large
customer sale or purchase); \834\ ensuring that markets continue to
have sufficient liquidity; \835\ fostering a two-way market; and
establishing a market-making presence.\836\ Some commenters noted that
market makers may need to accumulate inventory to meet customer demand
for certain products or under certain trading scenarios, such as to
create units of structured products (e.g., ETFs and asset-backed
securities) \837\ and in anticipation of an index rebalance.\838\
---------------------------------------------------------------------------

    \829\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);
Credit Suisse (Seidel); Goldman (Prop. Trading); MFA; RBC. Inventory
management is addressed in Part IV.A.3.c.2.c., infra.
    \830\ See, e.g., MFA (stating that it is critical for banking
entities to continue to be able to maintain sufficient levels of
inventory, which is dynamic in nature and requires some degree of
flexibility in application); RBC (requesting that the Agencies
explicitly acknowledge that, depending on market conditions or the
characteristics of a particular security, it may be appropriate or
necessary for a firm to maintain inventories over extended periods
of time in the course of market making-related activities).
    \831\ See, e.g., RBC; NYSE Euronext; Fidelity. These commenters
cited a colloquy in the Congressional Record between Senator Bayh
and Senator Dodd, in which Senator Bayh stated: ``With respect to
[section 13 of the BHC Act], the conference report states that
banking entities are not prohibited from purchasing and disposing of
securities and other instruments in connection with underwriting or
market-making activities, provided that activity does not exceed the
reasonably expected near-term demands of clients, customers, or
counterparties. I want to clarify this language would allow banks to
maintain an appropriate dealer inventory and residual risk
positions, which are essential parts of the market-making function.
Without that flexibility, market makers would not be able to provide
liquidity to markets.'' 156 Cong. Rec. S5906 (daily ed. July 15,
2010) (statement of Sen. Bayh).
    \832\ See, e.g., RBC.
    \833\ See Goldman (Prop. Trading).
    \834\ See id.
    \835\ See MFA.
    \836\ See RBC.
    \837\ See Goldman (Prop. Trading); BoA.
    \838\ See Oliver Wyman (Feb. 2012). As this commenter explained,
some mutual funds and ETFs track major equity indices and, when the
composition of an index changes (e.g., due to the addition or
removal of a security or to rising or falling values of listed
shares), an announcement is made and all funds tracking the index
need to rebalance their portfolios. According to the commenter,
banking entities may need to step in to provide liquidity for
rebalances of less liquid indices because trades executed on the
open market would substantially affect share prices. The commenter
estimated that if market makers are not able to provide direct
liquidity for rebalance trades, investors tracking these indices
could potentially pay incremental costs of $600 million to $1.8
billion every year. This commenter identified the proposed inventory
metrics in Appendix A as potentially limiting a banking entity's
willingness or ability to facilitate index rebalance trades. See id.
Two other commenters also discussed the index rebalancing scenario.
See Prof. Duffie; Thakor Study. Index rebalancing is addressed in
note 931, infra.
---------------------------------------------------------------------------

    Commenters also expressed views with respect to how much discretion
a banking entity should have to manage its inventory under the
exemption and how to best monitor inventory levels. For example, one
commenter recommended that the rule allow market makers to build
inventory in products where they believe customer demand will exist,
regardless of whether the inventory can be tied to a particular
customer in the near term or to historical trends in customer
demand.\839\ A few commenters suggested that the Agencies provide
banking entities with greater discretion to accumulate inventory, but
discourage market makers from holding inventory for long periods of
time by imposing increasingly higher capital requirements on aged
inventory.\840\ One commenter

represented that a trading unit's inventory management practices could
be monitored with the Inventory Risk Turnover metric, in conjunction
with other metrics.\841\
---------------------------------------------------------------------------

    \839\ See Credit Suisse (Seidel).
    \840\ See CalPERS; Vanguard. These commenters represented that
placing increasing capital requirements on aged inventory would ease
the rule's impact on investor liquidity, allow banking entities to
internalize the cost of continuing to hold a position at the expense
of its ability to take on new positions, and potentially decrease
the possibility of a firm realizing a loss on a position by
decreasing the time such position is held. See id. One commenter
noted that some banking entities already use this approach to manage
risk on their market-making desks. See Vanguard. See also Capital
Group (suggesting that one way to implement the statutory exemption
would be to charge a trader or a trading desk for positions held on
its balance sheet beyond set time periods and to increase the charge
at set intervals). These comments are addressed in note 923, infra.
    \841\ See Goldman (Prop. Trading) (representing that the
Inventory Risk Turnover metric will allow the Agencies to evaluate
the length of time that a trading unit tends to hold risk positions
in inventory and whether that holding time is consistent with market
making-related activities in the relevant market).
---------------------------------------------------------------------------

vii. Acting as an Authorized Participant or Market Maker in Exchange-
Traded Funds
    With respect to ETF trading, commenters generally requested
clarification that a banking entity can serve as an authorized
participant (``AP'') to an ETF issuer or can engage in ETF market
making under the proposed exemption.\842\ According to commenters, APs
may engage in the following types of activities with respect to ETFs:
(i) trading directly with the ETF issuer to create or redeem ETF
shares, which involves trading in ETF shares and the underlying
components; \843\ (ii) trading to maintain price alignment between the
ETF shares and the underlying components; \844\ (iii) traditional
market-making activity; \845\ (iv) ``seeding'' a new ETF by entering
into several initial creation transactions with an ETF issuer and
holding the ETF shares, possibly for an extended period of time, until
the ETF establishes regular trading and liquidity in the secondary
markets; \846\ (v) ``create to lend'' transactions, where an AP enters
a creation transaction with the ETF issuer and lends the ETF shares to
an investor; \847\ and (vi) hedging.\848\ A few commenters noted that
an AP may not engage in traditional market-making activity in the
relevant ETF and expressed concern that the proposed rule may limit a
banking entity's ability to act in an AP capacity.\849\ One commenter
estimated that APs that are banking entities make up between 20 percent
to 100 percent of creation and redemption activity for individual ETFs,
with an average of approximately 35 percent of creation and redemption
activity across all ETFs attributed to banking entities. This commenter
expressed the view that, if the rule limits banking entities' ability
to serve as APs, then individual investors' investments in ETFs will
become more expensive due to higher premiums and discounts versus the
ETF's NAV.\850\
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    \842\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);
Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); BoA; ICI
(stating that an AP may trade with the ETF issuer in different
capacities--in connection with traditional market-making activity,
on behalf of customers, or for the AP's own account); ICI Global
(discussing non-U.S. ETFs specifically); Vanguard; SSgA (Feb. 2012).
One commenter represented that an AP's transactions in ETFs do not
create risks associated with proprietary trading because, when an AP
trades with an ETF issuer for its own account, the AP typically
enters into an offsetting transaction in the underlying portfolio of
securities, which cancels out investment risk and limits the AP's
exposure to the difference between the market price for ETF shares
and the ETF's net asset value (``NAV''). See Vanguard.
    With respect to market-making activity in an ETF, several
commenters noted that market makers play an important role in
maintaining price alignment by engaging in arbitrage transactions
between the ETF shares and the shares of the underlying components.
See, e.g., JPMC; Goldman (Prop. Trading) (making similar statement
with respect to ADRs as well); SSgA (Feb. 2012); SIFMA et al. (Prop.
Trading) (Feb. 2012); Credit Suisse (Seidel); RBC. AP and market
maker activity in ETFs are addressed in Part IV.A.3.c.2.c.i., infra.
    \843\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; ICI
(Feb. 2012) ICI Global; Vanguard; SSgA (Feb. 2012).
    \844\ See JPMC; Goldman (Prop. Trading); SIFMA et al. (Prop.
Trading) (Feb. 2012); SSgA (Feb. 2012); ICI (Feb. 2012) ICI Global.
    \845\ See ICI Global; ICI (Feb. 2012) SIFMA et al. (Prop.
Trading) (Feb. 2012); BoA.
    \846\ See BoA; ICI (Feb. 2012); ICI Global.
    \847\ See BoA (stating that lending the ETF shares to an
investor gives the investor a more efficient way to hedge its
exposure to assets correlated with those underlying the ETF).
    \848\ See ICI Global; ICI (Feb. 2012).
    \849\ See, e.g., Vanguard (noting that APs may not engage in
market-making activity in the ETF and expressing concern that if AP
activities are not separately permitted, banking entities may exit
or not enter the ETF market); SSgA (Feb. 2012) (stating that APs are
under no obligation to make markets in ETF shares and requiring such
an obligation would discourage banking entities from acting as APs);
ICI (Feb. 2012).
    \850\ See SSgA (Feb. 2012). This commenter further stated that
as of 2011, an estimated 3.5 million--or 3 percent--of U.S.
households owned ETFs and, as of September 2011, ETFs represented
assets of approximately $951 billion. See id.
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    A number of commenters stated that certain requirements of the
proposed exemption may limit a banking entity's ability to serve as AP
to an ETF, including the proposed near term customer demand
requirement,\851\ the proposed source of revenue requirement,\852\ and
language in the proposal regarding arbitrage trading.\853\ With respect
to the proposed near term customer demand requirement, a few commenters
noted that this requirement could prevent an AP from building inventory
to assemble creation units.\854\ Two other commenters expressed the
view that the ETF issuer would be the banking entity's ``counterparty''
when the banking entity trades directly with the ETF issuer, so this
trading and inventory accumulation would meet the terms of the proposed
requirement.\855\ To permit banking entities to act as APs, two
commenters suggested that trading in the capacity of an AP should be
deemed permitted market making-related activity, regardless of whether
the AP is acting as a traditional market maker.\856\
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    \851\ See BoA; Vanguard (stating that this determination may be
particularly difficult in the case of a new ETF).
    \852\ See BoA. This commenter noted that the proposed source of
revenue requirement could be interpreted to prevent a banking entity
acting as AP from entering into creation and redemption
transactions, ``Seeding'' an ETF, engaging in ``create to lend''
transactions, and performing secondary market making in an ETF
because all of these activities require an AP to build an
inventory--either in ETF shares or the underlying components--which
often result in revenue attributable to price movements. See id.
    \853\ Commenters noted that this language would restrict an AP
from engaging in price arbitrage to maintain efficient markets in
ETFs. See Vanguard; RBC; Goldman (Prop. Trading); JPMC; SIFMA et al.
(Prop. Trading) (Feb. 2012). See supra Part IV.A.3.c.2.a.
(discussing the proposal's proposed interpretation regarding
arbitrage trading).
    \854\ See BoA; Vanguard (stating that this determination may be
particularly difficult in the case of a new ETF).
    \855\ See ICI Global; ICI (Feb. 2012).
    \856\ See ICI (Feb. 2012) ICI Global. These commenters provided
suggested rule text on this issue and suggested that the Agencies
could require a banking entity's compliance policies and internal
controls to take a comprehensive approach to the entirety of an AP's
trading activity, which would facilitate easy monitoring of the
activity to ensure compliance. See id.
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viii. Arbitrage or Other Activities That Promote Price Transparency and
Liquidity
    In response to a question in the proposal,\857\ a number of
commenters stated that certain types of arbitrage activity should be
permitted under the market-making exemption.\858\ For example, some
commenters stated that a banking entity's arbitrage activity should be
considered market making to the extent the activity is driven by
creating markets for customers tied to the price differential (e.g.,
``box'' strategies, ``calendar spreads,'' merger arbitrage, ``Cash and
Carry,'' or basis trading) \859\ or to the extent that demand is
predicated on specific price relationships between instruments (e.g.,
ETFs, ADRs) that market makers must

maintain.\860\ Similarly, another commenter suggested that arbitrage
activity that aligns prices should be permitted, such as index
arbitrage, ETF arbitrage, and event arbitrage.\861\ One commenter noted
that many markets, such as futures and options markets, rely on
arbitrage activities of market makers for liquidity purposes and to
maintain convergence with underlying instruments for cash-settled
options, futures, and index-based products.\862\ Commenters stated that
arbitrage trading provides certain market benefits, including enhanced
price transparency,\863\ increased market efficiency,\864\ greater
market liquidity,\865\ and general benefits to customers.\866\ A few
commenters noted that certain types of hedging activity may appear to
have characteristics of arbitrage trading.\867\
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    \857\ See Joint Proposal, 76 FR 68,873 (question 91) (inquiring
whether the proposed exemption should be modified to permit certain
arbitrage trading activities engaged in by market makers that
promote liquidity or price transparency but do not service client,
customer, or counterparty demand); CFTC Proposal, 77 FR 8359.
    \858\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);
Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); FTN; RBC;
ISDA (Feb. 2012). Arbitrage trading is further discussed in Part
IV.A.3.c.2.c.i., infra.
    \859\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \860\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.
    \861\ See Credit Suisse (Seidel).
    \862\ See RBC.
    \863\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \864\ See Credit Suisse (Seidel); RBC.
    \865\ See RBC.
    \866\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; FTN;
ISDA (Feb. 2012) (stating that arbitrage activities often yield
positions that are ultimately put to use in serving customer demand
and representing that the process of consistently trading makes a
dealer ready and available to serve customers on a competitive
basis).
    \867\ See JPMC (stating that firms commonly organize their
market-making activities so that risks delivered to client-facing
desks are aggregated and transferred by means of internal
transactions to a single utility desk (which hedges all of the risks
in the aggregate), and this may optically bear some characteristics
of arbitrage, although the commenter requested that such activity be
recognized as permitted market making-related activity under the
rule); ISDA (Feb. 2012) (stating that in some swaps markets, dealers
hedge through multiple instruments, which can give an impression of
arbitrage in a function that is risk reducing; for example, a dealer
in a broad index equity swap may simultaneously hedge in baskets of
stocks, futures, and ETFs). But See Sens. Merkley & Levin (Feb.
2012) (``When banks use complex hedging techniques or otherwise
engage in trading that is suggestive of arbitrage, regulators should
require them to provide evidence and analysis demonstrating what
risk is being reduced.'').
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    Commenters suggested certain methods for permitting and monitoring
arbitrage trading under the exemption. For example, one commenter
suggested a framework for permitting certain arbitrage within the
market-making exemption, with requirements such as: (i) Common
personnel with market-making activity; (ii) policies that cover the
timing and appropriateness of arbitrage positions; (iii) time limits on
arbitrage positions; and (iv) compensation that does not reward
successful arbitrage, but instead pools any such revenues with market-
making profits and losses.\868\ A few commenters represented that, if
permitted under the rule, the Agencies would be able to monitor
arbitrage activities for patterns of impermissible proprietary trading
through the use of metrics, as well as compliance and examination
tools.\869\
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    \868\ See FTN.
    \869\ See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; Goldman
(Prop. Trading). One of these commenters stated that the customer-
facing activity category of metrics, as well as other metrics, would
be available to evaluate whether the trading unit is engaged in a
directly customer-facing business and the extent to which its
activities are consistent with the market-making exemption. See
Goldman (Prop. Trading).
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    Other commenters stated that the exemption should not permit
certain types of arbitrage. One commenter stated that the rule should
ensure that relative value and complex arbitrage strategies cannot be
conducted.\870\ Another commenter expressed the view that the market-
making exemption should not permit any type of arbitrage transactions.
This commenter stated that, in the event that liquidity or transparency
is inhibited by a lack of arbitrage trading, a market maker should be
able to find a customer who would seek to benefit from it.\871\
---------------------------------------------------------------------------

    \870\ See Johnson & Prof. Stiglitz. See also AFR et al. (Feb.
2012) (noting that arbitrage, spread, or carry trades are a classic
type of proprietary trade).
    \871\ See Occupy.
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ix. Primary Dealer Activities
    A number of commenters requested that the market-making exemption
permit banking entities to meet their primary dealer obligations in
foreign jurisdictions, particularly if trading in foreign sovereign
debt is not separately exempted in the final rule.\872\ According to
commenters, a banking entity may be obligated to perform the following
activities in its capacity as a primary dealer: undertaking to maintain
an orderly market, preventing or correcting any price
dislocations,\873\ and bidding on each issuance of the relevant
jurisdiction's sovereign debt.\874\ Commenters expressed concern that a
banking entity's trading activity as primary dealer may not comply with
the proposed near term customer demand requirement \875\ or the
proposed source of revenue requirement.\876\ To address the first
issue, one commenter stated that the final rule should clarify that a
banking entity acting as a primary dealer of foreign sovereign debt is
engaged in primary dealer activity in response to the near term demands
of the sovereign, which should be considered a client, customer, or
counterparty of the banking entity.\877\ Another commenter suggested
that the Agencies permit primary dealer activities through commentary
stating that fulfilling primary dealer obligations will not be included
in determinations of whether the market-making exemption applies to a
trading unit.\878\
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    \872\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012)
(stating that permitted activities should include trading necessary
to meet the relevant jurisdiction's primary dealer and other
requirements); JPMC (indicating that the exemption should cover 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); Goldman (Prop. Trading); Banco de M[eacute]xico; IIB/
EBF. See infra notes 905 to 906 and accompanying text (addressing
these comments).
    \873\ See Goldman (Prop. Trading).
    \874\ See Banco de M[eacute]xico.
    \875\ See JPMC; Banco de M[eacute]xico. These commenters stated
that a primary dealer is required to assume positions in foreign
sovereign debt even when near term customer demand is unpredictable.
See id.
    \876\ See Banco de M[eacute]xico (stating that primary dealers
need to be able to profit from their positions in sovereign debt,
including by holding significant positions in anticipation of future
price movements, so that the primary dealer business is financially
attractive); IIB/EBF (stating that primary dealers may actively Seek
to profit from price and interest rate movements based on their debt
holdings, which governments support as providing much-needed
liquidity for securities that are otherwise purchased largely
pursuant to buy-and-hold strategies of institutional investors and
other entities Seeking safe returns and liquidity buffers).
    \877\ See Goldman (Prop. Trading).
    \878\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
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x. New or Bespoke Products or Customized Hedging Contracts
    Several commenters indicated that the proposed exemption does not
adequately address market making in new or bespoke products, including
structured, customer-driven transactions, and requested that the rule
be modified to clearly permit such activity.\879\ Many of these
commenters emphasized the role such transactions play in helping
customers hedge the unique risks they face.\880\ Commenters stated
that, as a result, limiting a banking entity's ability to conduct such
transactions would subject customers to increased risks and greater
transaction costs.\881\ One commenter suggested that the Agencies
explicitly state that a banking entity's general willingness to engage
in bespoke transactions is sufficient to make it a market maker in
unique products for purposes of the rule.\882\
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    \879\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);
Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); SIFMA (Asset
Mgmt.) (Feb. 2012). This issue is addressed in Part
IV.A.3.c.1.c.iii., supra, and Part IV.A.3.c.2.c.iii., infra.
    \880\ See Credit Suisse (Seidel); Goldman (Prop. Trading); SIFMA
(Asset Mgmt.) (Feb. 2012).
    \881\ See Goldman (Prop. Trading); SIFMA (Asset Mgmt.) (Feb.
2012).
    \882\ See SIFMA (Asset Mgmt.) (Feb. 2012).
---------------------------------------------------------------------------

    Other commenters stated that banking entities should be limited in
their ability to rely on the market-making exemption to conduct
transactions in bespoke or

customized derivatives.\883\ For example, one commenter suggested that
a banking entity be required to disaggregate such derivatives into
liquid risk elements and illiquid risk elements, with liquid risk
elements qualifying for the market-making exemption and illiquid risk
elements having to be conducted on a riskless principal basis under
Sec.  ----.6(b)(1)(ii) of the proposed rule. According to this
commenter, such an approach would not impact the end user
customer.\884\ Another commenter stated that a banking entity making a
market in bespoke instruments should be required both to hold itself
out in accordance with Sec.  ----.4(b)(2)(ii) of the proposed rule and
to demonstrate the purchase and the sale of such an instrument.\885\
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    \883\ See AFR et al. (Feb. 2012); Public Citizen.
    \884\ See AFR et al. (Feb. 2012).
    \885\ See Public Citizen.
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c. Final Near Term Customer Demand Requirement
    Consistent with the statute, Sec.  ----.4(b)(2)(ii) of the final
rule's market-making exemption requires that the amount, types, and
risks of the financial instruments in the trading desk's market-maker
inventory be designed not to exceed, on an ongoing basis, the
reasonably expected near term demands of clients, customers, or
counterparties, based on certain market factors and analysis.\886\ As
discussed above in Part IV.A.3.c.1.c.ii., the trading desk's market-
maker inventory consists of positions in financial instruments in which
the trading desk stands ready to purchase and sell consistent with the
final rule.\887\ The final rule requires the financial instruments to
be identified in the trading desk's compliance program. Thus, this
requirement focuses on a trading desk's positions in financial
instruments for which it acts as market maker. These positions of a
trading desk are more directly related to the demands of customers than
positions in financial instruments used for risk management purposes,
but in which the trading desk does not make a market. As noted above, a
position or exposure that is included in a trading desk's market-maker
inventory will remain in its market-maker inventory for as long as the
position or exposure is managed by the trading desk. As a result, the
trading desk must continue to account for that position or exposure,
together with other positions and exposures in its market-maker
inventory, in determining whether the amount, types, and risks of its
market-maker inventory are designed not to exceed, on an ongoing basis,