the reasonably expected near term demands of customers.
---------------------------------------------------------------------------

    \886\ The final rule includes certain refinements to the
proposed standard, which would have required that the market making-
related activities of the trading desk or other organizational unit
that conducts the purchase or sale are, with respect to the
financial instrument, designed not to exceed the reasonably expected
near term demands of clients, customers, or counterparties. See
proposed rule Sec.  ----.4(b)(2)(iii).
    \887\ See supra Part IV.A.3.c.1.c.ii.; final rule Sec.  --
--.4(b)(5).
---------------------------------------------------------------------------

    While the near term customer demand requirement directly applies
only to the trading desk's market-maker inventory, this does not mean a
trading desk may establish other positions, outside its market-maker
inventory, that exceed what is needed to manage the risks of the
trading desk's market making-related activities and inventory. Instead,
a trading desk must have limits on its market-maker inventory, the
products, instruments, and exposures the trading desk may use for risk
management purposes, and its aggregate financial exposure that are
based on the factors set forth in the near term customer demand
requirement, as well as other relevant considerations regarding the
nature and amount of the trading desk's market making-related
activities. A banking entity must establish, implement, maintain, and
enforce a limit structure, as well as other compliance program elements
(e.g., those specifying the instruments a trading desk trades as a
market maker or may use for risk management purposes and providing for
specific risk management procedures), for each trading desk that are
designed to prevent the trading desk from engaging in trading activity
that is unrelated to making a market in a particular type of financial
instrument or managing the risks associated with making a market in
that type of financial instrument.\888\
---------------------------------------------------------------------------

    \888\ See infra Part IV.A.3.c.3. (discussing the compliance
program requirements); final rule Sec.  ----.4(b)(2)(iii).
---------------------------------------------------------------------------

    To clarify the application of this standard in response to
comments,\889\ the final rule provides two factors for assessing
whether the amount, types, and risks of the financial instruments in
the trading desk's market-maker inventory are designed not to exceed,
on an ongoing basis, the reasonably expected near term demands of
clients, customers, or counterparties. Specifically, the following must
be considered under the revised standard: (i) The liquidity, maturity,
and depth of the market for the relevant type of financial
instrument(s),\890\ and (ii) demonstrable analysis of historical
customer demand, current inventory of financial instruments, and market
and other factors regarding the amount, types, and risks of or
associated with positions in financial instruments in which the trading
desk makes a market, including through block trades. Under the final
rule, a banking entity must account for these considerations when
establishing risk and inventory limits for each trading desk.\891\
---------------------------------------------------------------------------

    \889\ See supra Part IV.A.3.c.2.b.i.
    \890\ This language has been added to the final rule to respond
to commenters' concerns that the proposed near term demand
requirement would be unworkable in less liquid markets or would
otherwise restrict a market maker's ability to hold and manage its
inventory in less liquid markets. See supra Part IV.A.3.c.2.b.ii. In
addition, this provision is substantially similar to one commenter's
suggested approach of adding the phrase ``based on the
characteristics of the relevant market and asset class'' to the
proposed requirement, but the Agencies have added more specificity
about the relevant characteristics that should be taken into
consideration. See Morgan Stanley.
    \891\ See infra Part IV.A.3.c.3.
---------------------------------------------------------------------------

    For purposes of this provision, ``demonstrable analysis'' means
that the analysis for determining the amount, types, and risks of
financial instruments a trading desk may manage in its market-maker
inventory, in accordance with the near term demand requirement, must be
based on factors that can be demonstrated in a way that makes the
analysis reviewable. This may include, among other things, the normal
trading records of the trading desk and market information that is
readily available and retrievable. If the analysis cannot be supported
by the banking entity's books and records and available market data, on
their own, then the other factors utilized must be identified and
documented and the analysis of those factors together with the facts
gathered from the trading and market records must be identified in a
way that makes it possible to test the analysis.
    Importantly, a determination of whether a trading desk's market-
maker inventory is appropriate under this requirement will take into
account reasonably expected near term customer demand, including
historical levels of customer demand, expectations based on market
factors, and current demand. For example, at any particular time, a
trading desk may acquire a position in a financial instrument in
response to a customer's request to sell the financial instrument or in
response to reasonably expected customer buying interest for such
instrument in the near term.\892\ In addition, as discussed below, this
requirement is not intended to impede a trading desk's ability to
engage in

certain market making-related activities that are consistent with and
needed to facilitate permissible trading with its clients, customers,
or counterparties, such as inventory management and interdealer
trading. These activities must, however, be consistent with the
analysis conducted under the final rule and the trading desk's limits
discussed below.\893\ Moreover, as explained below, the banking entity
must also have in place escalation procedures to address, analyze, and
document trades made in response to customer requests that would exceed
one of a trading desk's limits.
---------------------------------------------------------------------------

    \892\ As discussed further below, acquiring a position in a
financial instrument in response to reasonably expected customer
demand would not include creating a structured product for which
there is no current customer demand and, instead, soliciting
customer demand during or after its creation. See infra note 938 and
accompanying text; Sens. Merkley & Levin (Feb. 2012).
    \893\ The formation of structured finance products and
securitizations is discussed in detail in Part IV.B.2.b. of this
SUPPLEMENTARY INFORMATION.
---------------------------------------------------------------------------

    The near term demand requirement is an ongoing requirement that
applies to the amount, types, and risks of the financial instruments in
the trading desk's market-maker inventory. For instance, a trading desk
may acquire exposures as a result of entering into market-making
transactions with customers that are within the desk's market-marker
inventory and financial exposure limits. Even if the trading desk is
appropriately managing the risks of its market-maker inventory, its
market-maker inventory still must be consistent with the analysis of
the reasonably expected near term demands of clients, customers, and
counterparties and the liquidity, maturity and depth of the market for
the relevant instruments in the inventory. Moreover, the trading desk
must take action to ensure that its financial exposure does not exceed
its financial exposure limits.\894\ A trading desk may not maintain an
exposure in its market-maker inventory, irrespective of customer
demand, simply because the exposure is hedged and the resulting
financial exposure is below the desk's financial exposure limit. In
addition, the amount, types, and risks of financial instruments in a
trading desk's market-maker inventory would not be consistent with
permitted market-making activities if, for example, the trading desk
has a pattern or practice of retaining exposures in its market-maker
inventory, while refusing to engage in customer transactions when there
is customer demand for those exposures at commercially reasonable
prices.
---------------------------------------------------------------------------

    \894\ See final rule Sec.  ----.4(b)(2)(iii)(B), (C).
---------------------------------------------------------------------------

    The following is an example of the interplay between a trading
desk's market-maker inventory and financial exposure. An airline
company customer may seek to hedge its long-term exposure to price
fluctuations in jet fuel by asking a banking entity to create a
structured ten-year, $1 billion jet fuel swap for which there is no
liquid market. A trading desk that makes a market in energy swaps may
service its customer's needs by executing a custom jet fuel swap with
the customer and holding the swap in its market-maker inventory, if the
resulting transaction does not cause the trading desk to exceed its
market-maker inventory limit on the applicable class of instrument, or
the trading desk has received approval to increase the limit in
accordance with the authorization and escalation procedures under
paragraph (b)(2)(iii)(E). In keeping with the market-making exemption
as provided in the final rule, the trading desk would be required to
hedge the risk from this swap, either individually or as part of a set
of aggregated positions, if the trade would result in a financial
exposure that exceeds the desk's financial exposure limits. The trading
desk may hedge the risk of the swap, for example, by entering into one
or more futures or swap positions that are identified as permissible
hedging products, instruments, or exposures in the trading desk's
compliance program and that analysis, including correlation analysis as
appropriate, indicates would demonstrably reduce or otherwise
significantly mitigate risks associated with the financial exposure
from its market-making activities. Alternatively, if the trading desk
also acts as a market maker in crude oil futures, then the desk's
exposures arising from its market-making activities may naturally hedge
the jet fuel swap (i.e., it may reduce its financial exposure levels
resulting from such instruments).\895\ The trading desk must continue
to appropriately manage risks of its financial exposure over time in
accordance with its financial exposure limits.
---------------------------------------------------------------------------

    \895\ This natural hedge with futures would introduce basis risk
which, like other risks of the trading desk, must be managed within
the desk's limits.
---------------------------------------------------------------------------

    As discussed above, several commenters expressed concern that the
near-term customer demand requirement is too restrictive and that it
could impede a market maker's ability to build or retain inventory,
particularly in less liquid markets where demand is intermittent.\896\
Because customer demand in illiquid markets can be difficult to predict
with precision, market-maker inventory may not closely track customer
order flow. The Agencies acknowledge that market makers will face costs
associated with demonstrating that market-maker inventory is designed
not to exceed, on an ongoing basis, the reasonably expected near term
demands of customers, as required by the statute and the final rule
because this is an analysis that banking entities may not currently
undertake. However, the final rule includes certain modifications to
the proposed rule that are intended to reduce the negative impacts
cited by commenters, such as limitations on inventory management
activity and potential restrictions on market making in less liquid
instruments, which the Agencies believe should reduce the perceived
burdens of the proposed near term demand requirement. For example, the
final rule recognizes that liquidity, maturity, and depth of the market
vary across asset classes. The Agencies expect that the express
recognition of these differences in the rule should avoid unduly
impeding a market maker's ability to build or retain inventory. More
specifically, the Agencies recognize the relationship between market-
maker inventory and customer order flow can vary across asset classes
and that an inflexible standard for demonstrating that inventory does
not exceed reasonably expected near term demand could provide an
incentive to stop making markets in illiquid asset classes.
---------------------------------------------------------------------------

    \896\ See SIFMA (Asset Mgmt.) (Feb. 2012); T. Rowe Price; CIEBA;
ICI (Feb. 2012) RBC.
---------------------------------------------------------------------------

i. Definition of ``Client,'' ``Customer,'' and ``Counterparty''
    In response to comments requesting further definition of the terms
``client,'' ``customer,'' and ``counterparty'' for purposes of this
standard,\897\ the Agencies have defined these terms in the final rule.
In particular, the final rule defines ``client,'' ``customer,'' and
``counterparty'' as, on a collective or individual basis, ``market
participants that make use of the banking entity's market making-
related services by obtaining such services, responding to quotations,
or entering into a continuing relationship with respect to such
services.'' \898\ However, for purposes of the analysis supporting the
market-maker inventory held to meet the reasonably expected near-term
demands of clients, customers and counterparties, a client, customer,
or counterparty of the trading desk does not include a trading desk or
other organizational unit of another entity if that entity has $50
billion or more in total trading assets and liabilities, measured in
accordance with Sec.  ----.20(d)(1),\899\ unless the

trading desk documents how and why such trading desk or other
organizational unit should be treated as a customer or the transactions
are conducted anonymously on an exchange or similar trading facility
that permits trading on behalf of a broad range of market
participants.\900\
---------------------------------------------------------------------------

    \897\ See Japanese Bankers Ass'n.; Credit Suisse (Seidel);
Occupy; AFR et al. (Feb. 2012); Public Citizen.
    \898\ Final rule Sec.  ----.4(b)(3).
    \899\ See final rule Sec.  ----.4(b)(3)(i). The Agencies are
using a $50 billion threshold for these purposes in recognition that
firms engaged in substantial trading activity do not typically act
as customers to other market makers, while smaller regional firms
may Seek liquidity from larger firms as part of their market making-
related activities.
    \900\ See final rule Sec.  ----.4(b)(3)(i)(A), (B). In Appendix
C of the proposed rule, a trading unit engaged in market making-
related activities would have been required to describe how it
identifies its customers for purposes of the Customer-Facing Trading
Ratio, if applicable, including documentation explaining when, how,
and why a broker-dealer, swap dealer, security-based swap dealer, or
any other entity engaged in market making-related activities, or any
affiliate thereof, is considered to be a customer of the trading
unit. See Joint Proposal, 76 FR 68,964. While the proposed approach
would not have necessarily prevented any of these entities from
being considered a customer of the trading desk, it would have
required enhanced documentation and justification for treating any
of these entities as a customer. The final rule's exclusion from the
definition of client, customer, and counterparty is similar to the
proposed approach, but is more narrowly focused on firms that have
$50 billion or more trading assets and liabilities because, as noted
above, the Agencies believe firms engaged in such substantial
trading activity are less likely to act as customers to market
makers than smaller regional firms.
---------------------------------------------------------------------------

    The Agencies believe this definition is generally consistent with
the proposed interpretation of ``customer'' in the proposal. The
proposal generally provided that, for purposes of market making on an
exchange or other organized trading facility, a customer is any person
on behalf of whom a buy or sell order has been submitted. In the
context of the over-the-counter market, a customer was generally
considered to be a market participant that makes use of the market
maker's intermediation services, either by requesting such services or
entering into a continuing relationship for such services.\901\ The
definition of client, customer, and counterparty in the final rule
recognizes that, in the context of market making in a financial
instrument that is executed on an exchange or other organized trading
facility, a client, customer, or counterparty would be any person whose
buy or sell order executes against the banking entity's quotation
posted on the exchange or other organized trading facility.\902\ Under
these circumstances, the person would be trading with the banking
entity in response to the banking entity's quotations and obtaining the
banking entity's market making-related services. In the context of
market making in a financial instrument in the OTC market, a client,
customer, or counterparty generally would be a person that makes use of
the banking entity's intermediation services, either by requesting such
services (possibly via a request-for-quote on an established trading
facility) or entering into a continuing relationship with the banking
entity with respect to such services. For purposes of determining the
reasonably expected near-term demands of customers, a client, customer,
or counterparty generally would not include a trading desk or other
organizational unit of another entity that has $50 billion or more in
total trading assets except if the trading desk has a documented reason
for treating the trading desk or other organizational unit of such
entity as a customer or the trading desk's transactions are executed
anonymously on an exchange or similar trading facility that permits
trading on behalf of a broad range of market participants. The Agencies
believe that this exclusion balances commenters' suggested alternatives
of either defining as a client, customer, or counterparty anyone who is
on the other side of a market maker's trade \903\ or preventing any
banking entity from being a client, customer, or counterparty.\904\ The
Agencies believe that the first alternative is overly broad and would
not meaningfully distinguish between permitted market making-related
activity and impermissible proprietary trading. For example, the
Agencies are concerned that such an approach would allow a trading desk
to maintain an outsized inventory and to justify such inventory levels
as being tangentially related to expected market-wide demand. On the
other hand, preventing any banking entity from being a client,
customer, or counterparty under the final rule would result in an
overly narrow definition that would significantly impact banking
entities' ability to provide and access market making-related services.
For example, most banks look to market makers to provide liquidity in
connection with their investment portfolios.
---------------------------------------------------------------------------

    \901\ See Joint Proposal, 76 FR 68,960; CFTC Proposal, 77 FR
8439.
    \902\ See, e.g., Goldman (Prop. Trading) (explaining generally
how exchange-based market makers operate).
    \903\ See ISDA (Feb. 2012). In addition, a number of commenters
suggested that the rule should not limit broker-dealers from being
customers of a market maker. See SIFMA et al. (Prop. Trading) (Feb.
2012); Credit Suisse (Seidel); RBC; Comm. on Capital Markets
Regulation.
    \904\ See AFR et al. (Feb. 2012); Occupy; Public Citizen.
---------------------------------------------------------------------------

    The Agencies further note that, with respect to a banking entity
that acts as a primary dealer (or functional equivalent) for a
sovereign government, the sovereign government and its central bank are
each a client, customer, or counterparty for purposes of the market-
making exemption as well as the underwriting exemption.\905\ The
Agencies believe this interpretation, together with the modifications
in the rule that eliminate the requirement to distinguish between
revenues from spreads and price appreciation and the recognition that
the market-making exemption extends to market making-related activities
appropriately captures the unique relationship between a primary dealer
and the sovereign government. Thus, generally a banking entity may rely
on the market-making exemption for its activities as primary dealer (or
functional equivalent) to the extent those activities are outside of
the underwriting exemption.\906\
---------------------------------------------------------------------------

    \905\ A primary dealer is a firm that trades a sovereign
government's obligations directly with the sovereign (in many cases,
with the sovereign's central bank) as well as with other customers
through market making. The sovereign government may impose
conditions on a primary dealer or require that it engage in certain
trading in the relevant government obligations (e.g., participate in
auctions for the government obligation or maintain a liquid
secondary market in the government obligations). Further, a
sovereign government may limit the number of primary dealers that
are authorized to trade with the sovereign. A number of countries
use a primary dealer system, including Australia, Brazil, Canada,
China-Hong Kong, France, Germany, Greece, India, Indonesia, Ireland,
Italy, Japan, Mexico, Netherlands, Portugal, South Africa, South
Korea, Spain, Turkey, the U.K., and the U.S. See, e.g., Oliver Wyman
(Feb. 2012). The Agencies note that this standard would similarly
apply to the relationship between a banking entity and a sovereign
that does not have a formal primary dealer system, provided the
sovereign's process functions like a primary dealer framework.
    \906\ See Goldman (Prop. Trading). See also supra Part
IV.A.3.c.2.b.ix. (discussing commenters' concerns regarding primary
dealer activity). Each suggestion regarding the treatment of primary
dealer activity has not been incorporated into the rule.
Specifically, the exemption for market making as applied to a
primary dealer does not extend without limitation to primary dealer
activities that are not conducted under the conditions of one of the
exemptions. These interpretations would be inconsistent with
Congressional intent for the statute, to limit permissible market-
making activity through the statute's near term demand requirement
and, thus, does not permit trading without limitation. See 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. Rather, recognizing that market
making by primary dealers is a key function, the limits and other
conditions of the rule are flexible enough to permit necessary
market making-related activities.
---------------------------------------------------------------------------

    For exchange-traded funds (``ETFs'') (and related structures),
Authorized Participants (``APs'') are generally the conduit for market
participants seeking to create or redeem shares of the fund

(or equivalent structure).\907\ For example, an AP may buy ETF shares
from market participants who would like to redeem those shares for cash
or a basket of instruments upon which the ETF is based. To provide this
service, the AP may in turn redeem these shares from the ETF itself.
Similarly, an AP may receive cash or financial instruments from a
market participant seeking to purchase ETF shares, in which case the AP
may use that cash or set of financial instruments to create shares from
the ETF. In either case, for the purpose of the market-making
exemption, such market participants as well as the ETF itself would be
considered clients, customers, or counterparties of the AP.\908\ The
inventory of ETF shares or underlying instruments held by the AP can
therefore be evaluated under the criteria of the market-making
exemption, such as how these holdings relate to reasonably expected
near term customer demand.\909\ These criteria can be similarly applied
to other activities of the AP, such as building inventory to ``seed'' a
new ETF or engaging in ETF-loan related transactions.\910\ The Agencies
recognize that banking entities currently conduct a substantial amount
of AP creation and redemption activity in the ETF market and, thus, if
the rule were to prevent or restrict a banking entity from acting as an
AP for an ETF, then the rule would impact the functioning of the ETF
market.\911\
---------------------------------------------------------------------------

    \907\ ETF sponsors enter into relationships with one or more
financial institutions that become APs for the ETF. Only APs are
permitted to purchase and redeem shares directly from the ETF, and
they can do so only in large aggregations or blocks that are
commonly called ``creation units.'' In response to a question in the
proposal, a number of commenters expressed concern that the proposed
market-making exemption may not permit certain AP and market maker
activities in ETFs and requested clarification that these activities
would be permitted under the market-making exemption. See Joint
Proposal, 76 FR 68,873 (question 91) (``Do particular markets or
instruments, such as the market for exchange-traded funds, raise
particular issues that are not adequately or appropriately addressed
in the proposal? If so, how could the proposal better address those
instruments, markets or market features?''); CFTC Proposal, 77 FR
8359 (question 91); supra Part IV.A.3.c.2.b.vii. (discussing
comments on this issue).
    \908\ This is consistent with two commenters' request that an
ETF issuer be considered a ``counterparty'' of the banking entity
when it trades directly with the ETF issuer as an AP. See ICI
Global; ICI (Feb. 2012). Further, this approach is intended to
address commenters' concerns that the near term demand requirement
may limit a banking entity's ability to act as AP for an ETF. See
BoA; Vanguard. The Agencies believe that one commenter's concern
about the impact of the proposed source of revenue requirement on AP
activity should be addressed by the replacement of this proposed
requirement with a metric-based focus on when a trading desk
generates revenue from its trading activity. See BoA; infra Part
IV.A.3.c.7.c. (discussing the new approach to assessing a trading
desk's pattern of profit and loss).
    \909\ This does not imply that the AP must perfectly predict
future customer demand, but rather that there is a demonstrable,
statistical, or historical basis for the size of the inventory held,
as more fully discussed below. Consider, for example, a fixed-income
ETF with $500 million in assets. If, on a typical day, an AP
generates requests for $10 to $20 million of creations or
redemptions, then an inventory of $10 to $20 million in bonds upon
which the ETF is based (or some small multiple thereof) could be
construed as consistent with reasonably expected near term customer
demand. On the other hand, if under the same circumstances an AP
holds $1 billion of these bonds solely in its capacity as an AP for
this ETF, it would be more difficult to justify this as needed for
reasonably expected near term customer demand and may be indicative
of an AP engaging in prohibited proprietary trading.
    \910\ In ETF loan transactions (also referred to as ``create-to-
lend'' transactions), an AP borrows the underlying instruments that
form the creation basket of an ETF, submits the borrowed instruments
to the ETF agent in exchange for a creation unit of ETF shares, and
lends the resulting ETF shares to a customer that wants to borrow
the ETF. At the end of the ETF loan, the borrower returns the ETF
shares to the AP, and the AP redeems the ETF shares with the ETF
agent in exchange for the underlying instruments that form the
creation basket. The AP may return the underlying instruments to the
parties from whom it borrowed them or may use them for another loan,
as long as the AP is not obligated to return them at that time. For
the term of the ETF loan transaction, the AP hedges against market
risk arising from any rebalancing of the ETF, which would change the
amount or type of underlying instruments the AP would receive in
exchange for the ETF compared to the underlying instruments the AP
borrowed and submitted to the ETF agent to create the ETF shares.
See David J. Abner, The ETF Handbook, Ch. 12 (2010); Jean M.
McLoughlin, Davis Polk & Wardwell LLP, to Division of Corporation
Finance, U.S. Securities and Exchange Commission, dated Jan. 23,
2013, available at http://www.sec.gov/divisions/corpfin/cf-noaction/2013/davis-polk-wardwell-llp-012813-16a.pdf.
    \911\ See SSgA (Feb. 2012).
---------------------------------------------------------------------------

    Some firms, whether or not an AP in a given ETF, may also actively
engage in buying and selling shares of an ETF and its underlying
instruments in the market to maintain price continuity between the ETF
and its underlying instruments, which are exchangeable for one another.
Sometimes these firms will register as market makers on an exchange for
a given ETF, but other times they may not register as market maker.
Regardless of whether or not the firm is registered as a market maker
on any given exchange, this activity not only provides liquidity for
ETFs, but also, and very importantly, helps keep the market price of an
ETF in line with the NAV of the fund. The market-making exemption can
be used to evaluate trading that is intended to maintain price
continuity between these exchangeable instruments by considering how
the firm quotes, maintains risk and exposure limits, manages its
inventory and risk, and, in the case of APs, exercises its ability to
create and redeem shares from the fund. Because customers take
positions in ETFs with an expectation that the price relationship will
be maintained, such trading can be considered to be market making-
related activity.\912\
---------------------------------------------------------------------------

    \912\ A number of commenters expressed concern that the proposed
rule would limit market making or AP activity in ETFs because market
makers and APs engage in trading to maintain a price relationship
between ETFs and their underlying components, which promotes ETF
market efficiency. See Vanguard; RBC; Goldman (Prop. Trading); JPMC;
SIFMA et al. (Prop. Trading) (Feb. 2012); SSgA (Feb. 2012); Credit
Suisse (Prop. Trading).
---------------------------------------------------------------------------

    After considering comments, the Agencies continue to take the view
that a trading desk would not qualify for the market-making exemption
if it is wholly or principally engaged in arbitrage trading or other
trading that is not in response to, or driven by, the demands of
clients, customers, or counterparties.\913\ The Agencies believe this
activity, which is not in response to or driven by customer demand, is
inconsistent with the Congressional intent that market making-related
activity be designed not to exceed the reasonably expected near term
demands of clients, customers, or counterparties. For example, a
trading desk would not be permitted to engage in general statistical
arbitrage trading between instruments that have some degree of
correlation but where neither instrument has the capability of being
exchanged, converted, or exercised for or into the other instrument. A
trading desk may, however, act as market maker to a customer engaged in
a statistical arbitrage trading strategy. Furthermore as suggested by
some commenters,\914\ trading activity used by a market maker to
maintain a price relationship that is expected and relied upon by
clients, customers, and counterparties is permitted as it is related to
the demands of clients, customers, or counterparties because the
relevant instrument has the capability of being exchanged,

converted, or exercised for or into another instrument.\915\
---------------------------------------------------------------------------

    \913\ Some commenters suggested that a range of arbitrage
trading should be permitted under the market-making exemption. See,
e.g., Goldman (Prop. Trading); RBC; SIFMA et al. (Prop. Trading)
(Feb. 2012); JPMC. Other commenters, however, stated that arbitrage
trading should be prohibited under the final rule. See AFR et al.
(Feb. 2012); Volcker; Occupy. In response to commenters representing
that it would be difficult to comply with this standard because it
requires a trading desk to determine the proportionality of its
activities in response to customer demand compared to its activities
that are not in response to customer demand, the Agencies believe
that the statute requires a banking entity to distinguish between
market making-related activities that are designed not to exceed the
reasonably expected near term demands of customers and impermissible
proprietary trading. See Goldman (Prop. Trading); RBC.
    \914\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.
    \915\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC;
Credit Suisse (Seidel). For example, customers have an expectation
of general price alignment under these circumstances, both at the
time they decide to invest in the instrument and for the remaining
time they hold the instrument. To the contrary, general statistical
arbitrage does not maintain a price relationship between related
instruments that is expected and relied upon by customers and, thus,
is not permitted under the market-making exemption. Firms engage in
general statistical arbitrage to profit from differences in market
prices between instruments, assets, or price or risk elements
associated with instruments or assets that are thought to be
statistically related, but which do not have a direct relationship
of being exchangeable, convertible, or exercisable for the other.
---------------------------------------------------------------------------

    The Agencies recognize that a trading desk, in anticipating and
responding to customer needs, may engage in interdealer trading as part
of its inventory management activities and that interdealer trading
provides certain market benefits, such as more efficient matching of
customer order flow, greater hedging options to reduce risk, and
enhanced ability to accumulate or exit customer-related positions.\916\
The final rule does not prohibit a trading desk from using the market-
making exemption to engage in interdealer trading that is consistent
with and related to facilitating permissible trading with the trading
desk's clients, customers, or counterparties.\917\ However, in
determining the reasonably expected near term demands of clients,
customers, or counterparties, a trading desk generally may not account
for the expected trading interests of a trading desk or other
organizational unit of an entity with aggregate trading assets and
liabilities of $50 billion or greater (except if the trading desk
documents why and how a particular trading desk or other organizational
unit at such a firm should be considered a customer or the trading desk
or conduct market-making activity anonymously on an exchange or similar
trading facility that permits trading on behalf of a broad range of
market participants).\918\
---------------------------------------------------------------------------

    \916\ See MetLife; ACLI (Feb. 2012); Goldman (Prop. Trading);
Morgan Stanley; Chamber (Feb. 2012); Prof. Duffie; Oliver Wyman
(Dec. 2011); Oliver Wyman (Feb. 2012).
    \917\ A number of commenters requested that the rule be modified
to clearly recognize interdealer trading as a component of permitted
market making-related activity. 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). One of these commenters
analyzed the potential market impact of preventing interdealer
trading, combined with inventory limits. See Oliver Wyman (Feb.
2012). Because the final rule does not prohibit interdealer trading
or limit inventory in the manner this commenter assumed for purposes
of its analysis, the Agencies do not believe the final rule will
have the market impact cited by this commenter.
    \918\ See 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).
---------------------------------------------------------------------------

    A trading desk may engage in interdealer trading to: Establish or
acquire a position to meet the reasonably expected near term demands of
its clients, customers, or counterparties, including current demand;
unwind or sell positions acquired from clients, customers, or
counterparties; or engage in risk-mitigating or inventory management
transactions.\919\ The Agencies believe that allowing a trading desk to
continue to engage in customer-related interdealer trading is
appropriate because it can help a trading desk appropriately manage its
inventory and risk levels and can effectively allow clients, customers,
or counterparties to access a larger pool of liquidity. While the
Agencies recognize that effective intermediation of client, customer,
or counterparty trading may require a trading desk to engage in a
certain amount of interdealer trading, this is an activity that will
bear some scrutiny by the Agencies and should be monitored by banking
entities to ensure it reflects market-making activities and not
impermissible proprietary trading.
---------------------------------------------------------------------------

    \919\ Provided it is consistent with the requirements of the
market-making exemption, including the near term customer demand
requirement, a trading desk may trade for purposes of determining
how to price a financial instrument a customer Seeks to trade with
the trading desk or to determine the depth of the market for a
financial instrument a customer Seeks to trade with the trading
desk. See Goldman (Prop. Trading).
---------------------------------------------------------------------------

ii. Impact of the Liquidity, Maturity, and Depth of the Market on the
Analysis
    Several commenters expressed concern about the potential impact of
the proposed near term demand requirement on market making in less
liquid markets and requested that the Agencies recognize that near term
customer demand may vary across different markets and asset
classes.\920\ The Agencies understand that reasonably expected near
term customer demand may vary based on the liquidity, maturity, and
depth of the market for the relevant type of financial instrument(s) in
which the trading desk acts as market maker.\921\ As a result, the
final rule recognizes that these factors impact the analysis of
reasonably expected near term demands of clients, customers, or
counterparties and the amount, types, and risks of market-maker
inventory needed to meet such demand.\922\ In particular, customer
demand is likely to be more frequent in more liquid markets than in
less liquid or illiquid markets. As a result, market makers in more
liquid cash-based markets, such as liquid equity securities, should
generally have higher rates of inventory turnover and less aged
inventory than market makers in less liquid or illiquid markets.\923\
Market makers in less liquid cash-based markets are more likely to hold
a particular position for a longer period of time due to intermittent
customer demand. In the derivatives markets, market makers carry open
positions and manage various risk factors, such as exposure to
different points on a yield curve. These exposures are analogous to
inventory in the cash-based markets. Further, it may be more difficult
to reasonably predict near term customer demand in less mature markets
due to, among other things, a lack of historical experience with
client, customer, or counterparty demands for the relevant product.
Under these circumstances, the Agencies encourage banking entities to
consider their experience with similar products or other relevant
factors.\924\
---------------------------------------------------------------------------

    \920\ See 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);
Morgan Stanley; RBC; ICI (Feb. 2012) ISDA (Feb. 2012); Comm. on
Capital Markets Regulation; Alfred Brock.
    \921\ See supra Part IV.A.3.c.2.b.ii. (discussing comments on
this issue).
    \922\ See final rule Sec.  ----.4(b)(2)(ii)(A).
    \923\ The final rule does not impose additional capital
requirements on aged inventory to discourage a trading desk from
retaining positions in inventory, as suggested by some commenters.
See CalPERS; Vanguard. The Agencies believe the final rule already
limit a trading desk's ability to hold inventory over an extended
period and do not See a need at this time to include additional
capital requirements in the final rule. For example, a trading desk
must have written policies and procedures relating to its inventory
and must be able to demonstrate, as needed, its analysis of why the
levels of its market-maker inventory are necessary to meet, or is a
result of meeting, customer demand. See final rule Sec.  --
--.4(b)(2)(ii), (iii)(C).
    \924\ The Agencies agree, as suggested by one commenter, it may
be appropriate for a market maker in a new asset class or market to
look to reasonably expected future developments on the basis of the
trading desk's customer relationships. See Morgan Stanley. As
discussed further below, the Agencies recognize that a trading desk
could encounter similar issues if it is a new entrant in an existing
market.
---------------------------------------------------------------------------

iii. Demonstrable Analysis of Certain Factors
    In the proposal, the Agencies stated that permitted market making
includes taking positions in securities in anticipation of customer
demand, so long as any anticipatory buying or

selling activity is reasonable and related to clear, demonstrable
trading interest of clients, customers, or counterparties.\925\ A
number of commenters expressed concern about this proposed
interpretation's impact on market makers' inventory management activity
and represented that it was inconsistent with the statute's near term
demand standard, which permits market-making activity that is
``designed'' not to exceed the ``reasonably expected'' near term
demands of customers.\926\ In response to comments, the Agencies are
permitting a trading desk to take positions in reasonable expectation
of customer demand in the near term based on a demonstrable analysis
that the amount, types, and risks of the financial instruments in the
trading desk's market-maker inventory are designed not to exceed, on an
ongoing basis, the reasonably expected near term demands of customers.
---------------------------------------------------------------------------

    \925\ See Joint Proposal, 76 FR 68,871; CFTC Proposal, 77 FR
8356-8357.
    \926\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);
Goldman (Prop. Trading); Chamber (Feb. 2012); Comm. on Capital
Markets Regulation. See also Morgan Stanley; SIFMA (Asset Mgmt.)
(Feb. 2012).
---------------------------------------------------------------------------

    The proposal also stated that a banking entity's determination of
near term customer demand should generally be based on the unique
customer base of a specific market-making business line (and not merely
an expectation of future price appreciation). Several commenters stated
that it was unclear how such determinations should be made and
expressed concern that near term customer demand cannot always be
accurately predicted,\927\ particularly in markets where trades occur
infrequently and customer demand is hard to predict \928\ or when a
banking entity is entering a new market.\929\ To address these
comments, the Agencies are providing additional information about how a
banking entity can comply with the statute's near term customer demand
requirement, including a new requirement that a banking entity conduct
a demonstrable assessment of reasonably expected near term customer
demand and several examples of factors that may be relevant for
conducting such an assessment. The Agencies believe it is important to
require such demonstrable analysis to allow determinations of
reasonably expected near term demand and associated inventory levels to
be monitored and tested to ensure compliance with the statute and the
final rule.
---------------------------------------------------------------------------

    \927\ See SIFMA et al. (Prop. Trading) (Feb. 2012); MetLife;
Chamber (Feb. 2012); RBC; CIEBA; Wellington; ICI (Feb. 2012) Alfred
Brock.
    \928\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \929\ See CIEBA.
---------------------------------------------------------------------------

    The final rule provides that, to help determine the appropriate
amount, types, and risks of the financial instruments in the trading
desk's market-maker inventory and to ensure that such inventory is
designed not to exceed, on an ongoing basis, the reasonably expected
near term demands of client, customers, or counterparties, a banking
entity must conduct demonstrable analysis of historical customer
demand, current inventory of financial instruments, and market and
other factors regarding the amount, types, and risks of or associated
with financial instruments in which the trading desk makes a market,
including through block trades. This analysis should not be static or
fixed solely on current market or other factors. Instead, an
appropriately conducted analysis under this provision will be both
backward- and forward-looking by taking into account relevant
historical trends in customer demand \930\ and any events that are
reasonably expected to occur in the near term that would likely impact
demand.\931\ Depending on the facts and circumstances, it may be proper
for a banking entity to weigh these factors differently when conducting
an analysis under this provision. For example, historical trends in
customer demand may be less relevant when a trading desk is
experiencing or expects to experience a change in the pattern of
customer needs (e.g., requests for block positioning), adjustments to
its business model (e.g., efforts to expand or contract its market
shares), or changes in market conditions.\932\ On the other hand,
absent these types of current or anticipated events, the amount, types,
and risks of the financial instruments in the trading desk's market-
maker inventory should be relatively consistent with such trading
desk's historical profile of market-maker inventory.\933\
---------------------------------------------------------------------------

    \930\ To determine an appropriate historical dataset, a banking
entity should assess the relation between current or reasonably
expected near term conditions and demand and those of prior market
cycles.
    \931\ This analysis may, where appropriate, take into account
prior and/or anticipated cyclicality to the demands of clients,
customers, or counterparties, which may cause variations in the
amounts, types, and risks of financial instruments needed to provide
intermediation services at different points in a cycle. For example,
the final rule recognizes that a trading desk may need to accumulate
a larger-than-average amount of inventory in anticipation of an
index rebalance. See supra note 838 (discussing a comment on this
issue). The Agencies are aware that a trading desk engaged in block
positioning activity may have a less consistent pattern of inventory
because of the need to take on large block positions at the request
of customers. See supra note 761 and accompanying text (discussing
comments on this issue).
    Because the final rule does not prevent banking entities from
providing direct liquidity for rebalance trades, the Agencies do not
believe that the final rule will cause the market impacts that one
commenter predicted would occur were such a restriction adopted. See
Oliver Wyman (Feb. 2012) (estimating 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).
    \932\ In addition, the Agencies recognize that a new entrant to
a particular market or asset class may not have knowledge of
historical customer demand in that market or asset class at the
outset. See supra note 924 and accompanying text (discussing factors
that may be relevant to new market entrants for purposes of
determining the reasonably expected near term demands of clients,
customers, or counterparties).
    \933\ One commenter suggested an approach that would allow
market makers to build inventory in products where they believe
customer demand will exist, regardless of whether inventory can be
tied to a particular customer in the near term or to historical
trends in customer demand. See Credit Suisse (Seidel). The Agencies
believe an approach that does not provide for any consideration of
historical trends could result in a heightened risk of evasion. At
the same time, as discussed above, the Agencies recognize that
historical trends may not always determine the amount of inventory a
trading desk may need to meet reasonably expected near term demand
and it may under certain circumstances be appropriate to build
inventory in anticipation of a reasonably expected near term event
that would likely impact customer demand. While the Agencies are not
requiring that market-maker inventory be tied to a particular
customer, The Agencies are requiring that a banking entity analyze
and support its expectations for near term customer demand.
---------------------------------------------------------------------------

    Moreover, the demonstrable analysis required under Sec.  --
--.4(b)(2)(ii)(B) should account for, among other things, how the
market factors discussed in Sec.  ----.4(b)(2)(ii)(A) impact the
amount, types, and risks of market-maker inventory the trading desk may
need to facilitate reasonably expected near term demands of clients,
customers, or counterparties.\934\ Other potential factors that could
be used to assess reasonably expected near term customer demand and the
appropriate amount, types, and risks of financial instruments in the
trading desk's market-maker inventory include, among others: (i) Recent
trading volumes and customer trends; (ii) trading patterns of specific
customers or other observable customer demand patterns; (iii) analysis
of the banking entity's business plan and ability to win new customer
business; (iv) evaluation of expected demand under current market
conditions

compared to prior similar periods; (v) schedule of maturities in
customers' existing portfolios; and (vi) expected market events, such
as an index rebalancing, and announcements. The Agencies believe that
some banking entities already analyze these and other relevant factors
as part of their overall risk management processes.\935\
---------------------------------------------------------------------------

    \934\ The Agencies recognize that a trading desk could acquire
either a long or short position in reasonable anticipation of near
term demands of clients, customers, or counterparties. In
particular, if it is expected that customers will want to buy an
instrument in the near term, it may be appropriate for the desk to
acquire a long position in such instrument. If it is expected that
customers will want to sell the instrument, acquiring a short
position may be appropriate under certain circumstances.
    \935\ See supra Part IV.A.3.c.2.b.iii. See FTN; Morgan Stanley
(suggesting a standard that would require a position to be
``reasonably consistent with observable customer demand patterns'').
---------------------------------------------------------------------------

    With respect to the creation and distribution of complex structured
products, a trading desk may be able to use the market-making exemption
to acquire some or all of the risk exposures associated with the
product if the trading desk has evidence of customer demand for each of
the significant risks associated with the product.\936\ To have
evidence of customer demand under these circumstances, there must be
prior express interest from customers in the specific risk exposures of
the product. Without such express interest, a trading desk would not
have sufficient information to support the required demonstrable
analysis (e.g., information about historical customer demand or other
relevant factors).\937\ The Agencies are concerned that, absent express
interest in each significant risk associated with the product, a
trading desk could evade the market-making exemption by structuring a
deal with certain risk exposures, or amounts of risk exposures, for
which there is no customer demand and that would be retained in the
trading desk's inventory, potentially for speculative purposes. Thus, a
trading desk would not be engaged in permitted market making-related
activity if, for example, it structured a product solely to acquire a
desired exposure and not to respond to customer demand.\938\ When a
trading desk acquires risk exposures in these circumstances, the
trading desk would be expected to enter into appropriate hedging
transactions or otherwise mitigate the risks of these exposures,
consistent with its hedging policies and procedures and risk limits.
---------------------------------------------------------------------------

    \936\ Complex structured products can contain a combination of
several different types of risks, including, among others, market
risk, credit risk, volatility risk, and prepayment risk.
    \937\ In contrast, a trading desk may respond to requests for
customized transactions, such as custom swaps, provided that the
trading desk is a market maker in the risk exposures underlying the
swap or can hedge the underlying risk exposures, consistent with its
financial exposure and hedging limits, and otherwise meets the
requirements of the market-making exemption. For example, a trading
desk may routinely make markets in underlying exposures and, thus,
would meet the requirements for engaging in transactions in
derivatives that reflect the same exposures. Alternatively, a
trading desk might meet the requirements by routinely trading in the
derivative and hedging in the underlying exposures. See supra Part
IV.A.3.c.1.c.iii.
    \938\ See, e.g., Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

    With regard to a trading desk that conducts its market-making
activities on an exchange or other similar anonymous trading facility,
the Agencies continue to believe that market-making activities are
generally consistent with reasonably expected near term customer demand
when such activities involve passively providing liquidity by
submitting resting orders that interact with the orders of others in a
non-directional or market-neutral trading strategy or by regularly
responding to requests for quotes in markets where resting orders are
not generally provided. This ensures that the trading desk has a
pattern of providing, rather than taking, liquidity. However, this does
not mean that a trading desk acting as a market maker on an exchange or
other similar anonymous trading facility is only permitted to use these
types of orders in connection with its market making-related
activities. The Agencies recognize that it may be appropriate for a
trading desk to enter market or marketable limit orders on an exchange
or other similar anonymous trading facility, or to request quotes from
other market participants, in connection with its market making-related
activities for a variety of purposes including, among others, inventory
management, addressing order imbalances on an exchange, and
hedging.\939\ In response to comments, the Agencies are not requiring a
banking entity to be registered as a market maker on an exchange or
other similar anonymous trading facility, if the exchange or other
similar anonymous trading facility registers market makers, for
purposes of the final rule.\940\ The Agencies recognize, as noted by
commenters, that there are a large number of exchanges and organized
trading facilities on which market makers may need to trade to maintain
liquidity across the markets and to provide customers with favorable
prices and that requiring registration with each exchange or other
trading facility may unnecessarily restrict or impose burdens on
exchange market-making activities.\941\
---------------------------------------------------------------------------

    \939\ The Agencies are clarifying this point in response to
commenters who expressed concern that the proposal would prevent an
exchange market maker from using market or marketable limit orders
under these circumstances. See, e.g., NYSE Euronext; SIFMA et al.
(Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); RBC.
    \940\ See supra notes 774 to 779 and accompanying text
(discussing commenters' response to statements in the proposal
requiring exchange registration as a market maker under certain
circumstances). Similarly, the final rule does not establish a
presumption of compliance with the market-making exemption based on
registration as a market maker with an exchange, as requested by a
few commenters. See supra note 777 and accompanying text. As noted
above, activity that is considered market making for purposes of
this rule may not be considered market making for purposes of other
rules, including self-regulatory organization rules, and vice versa.
In addition, exchange requirements for registered market makers are
subject to change without consideration of the impact on this rule.
Although a banking entity is not required to be an exchange-
registered market maker under the final rule, a banking entity must
be licensed or registered to engage in market making-related
activities in accordance with applicable law. For example, a banking
entity would be required to be an SEC-registered broker-dealer to
engage in market making-related activities in securities in the U.S.
unless the banking entity is exempt from registration or excluded
from regulation as a dealer under the Exchange Act. See infra Part
IV.A.3.c.6.; final rule Sec.  ----.4(b)(2)(vi).
    \941\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman
(Prop. Trading) (noting that there are more than 12 exchanges and 40
alternative trading systems currently trading U.S. equities).
---------------------------------------------------------------------------

    A banking entity is not required to conduct the demonstrable
analysis under Sec.  ----.4(b)(2)(B) of the final rule on an
instrument-by-instrument basis. The Agencies recognize that, in certain
cases, customer demand may be for a particular type of exposure, and a
customer may be willing to trade any one of a number of instruments
that would provide the demanded exposure. Thus, an assessment of the
amount, types, and risks of financial instruments that the trading desk
may hold in market-maker inventory and that would be designed not to
exceed, on an ongoing basis, the reasonably expected near term demands
of clients, customers, or counterparties does not need to be made for
each financial instrument in which the trading desk acts as market
maker. Instead, the amount and types of financial instruments in the
trading desk's market-maker inventory should be consistent with the
types of financial instruments in which the desk makes a market and the
amount and types of such instruments that the desk's customers are
reasonably expected to be interested in trading.
    In response to commenters' concern that banking entities may be
subject to regulatory sanctions if reasonably expected customer demand
does not materialize,\942\ the Agencies recognize that predicting the
reasonably expected near term demands of clients, customers, or
counterparties is inherently subject to changes based on market and
other factors that are difficult to predict with certainty. Thus, there
may at times be differences between predicted demand and actual demand
from clients, customers, or

counterparties. However, assessments of expected near term demand may
not be reasonable if, in the aggregate and over longer periods of time,
a trading desk exhibits a repeated pattern or practice of significant
variation in the amount, types, and risks of financial instruments in
its market-maker inventory in excess of what is needed to facilitate
near term customer demand.
---------------------------------------------------------------------------

    \942\ See RBC; CIEBA; Wellington; ICI (Feb. 2012) Invesco.
---------------------------------------------------------------------------

iv. Relationship to Required Limits
    As discussed further below, a banking entity must establish limits
for each trading desk on the amount, types, and risks of its market-
maker inventory, level of exposures to relevant risk factors arising
from its financial exposure, and period of time a financial instrument
may be held by a trading desk. These limits must be reasonably designed
to ensure compliance with the market-making exemption, including the
near term customer demand requirement, and must take into account the
nature and amount of the trading desk's market making-related
activities. Thus, the limits should account for and generally be
consistent with the historical near term demands of the desk's clients,
customers, or counterparties and the amount, types, and risks of
financial instruments that the trading desk has historically held in
market-maker inventory to meet such demands. In addition to the limits
that a trading desk selects in managing its positions to ensure
compliance with the market-making exemption set out in Sec.  ----.4(b),
the Agencies are requiring, for banking entities that must report
metrics in Appendix A, such limits include, at a minimum, ``Risk Factor
Sensitivities'' and ``Value-at-Risk and Stress Value-at-Risk'' metrics
as limits, except to the extent any of the ``Risk Factor
Sensitivities'' or ``Value-at-Risk and Stress Value-at-Risk'' metrics
are demonstrably ineffective for measuring and monitoring the risks of
a trading desk based on the types of positions traded by, and risk
exposures of, that desk.\943\ The Agencies believe that these metrics
can be useful for measuring and managing many types of positions and
trading activities and therefore can be useful in establishing a
minimum set of metrics for which limits should be applied.\944\
---------------------------------------------------------------------------

    \943\ See Appendix A.
    \944\ The Agencies recognize that for some types of positions or
trading strategies, the use of ``Risk Factor Sensitivities'' and
``Value-at-Risk and Stress Value-at-Risk'' metrics may be
ineffective and accordingly limits do not need to be set for those
metrics if such ineffectiveness is demonstrated by the banking
entity.
---------------------------------------------------------------------------

    As this requirement applies on an ongoing basis, a trade in excess
of one or more limits set for a trading desk should not be permitted
simply because it responds to customer demand. Rather, a banking
entity's compliance program must include escalation procedures that
require review and approval of any trade that would exceed one or more
of a trading desk's limits, demonstrable analysis that the basis for
any temporary or permanent increase to one or more of a trading desk's
limits is consistent with the requirements of this near term demand
requirement and with the prudent management of risk by the banking
entity, and independent review of such demonstrable analysis and
approval.\945\ The Agencies expect that a trading desk's escalation
procedures will generally explain the circumstances under which a
trading desk's limits can be increased, either temporarily or
permanently, and that such increases must be consistent with reasonably
expected near term demands of the desk's clients, customers, or
counterparties and the amount and type of risks to which the trading
desk is authorized to be exposed.
---------------------------------------------------------------------------

    \945\ See final rule Sec.  ----.4(b)(2)(iii); infra Part
IV.A.3.c.3.c. (discussing the meaning of ``independent'' review for
purposes of this requirement).
---------------------------------------------------------------------------

3. Compliance Program Requirement
a. Proposed Compliance Program Requirement
    To ensure that a banking entity relying on the market-making
exemption had an appropriate framework in place to support its
compliance with the exemption, Sec.  ----.4(b)(2)(i) of the proposed
rule required a banking entity to establish an internal compliance
program, as required by subpart D of the proposal, designed to ensure
compliance with the requirements of the market-making exemption.\946\
---------------------------------------------------------------------------

    \946\ See proposed rule Sec.  ----.4(b)(2)(i); Joint Proposal,
76 FR 68,870; CFTC Proposal, 77 FR 8355.
---------------------------------------------------------------------------

b. Comments on the Proposed Compliance Program Requirement
    A few commenters supported the proposed requirement that a banking
entity establish a compliance program under Sec.  ----.20 of the
proposed rule as effective.\947\ For example, one commenter stated that
the requirement ``keeps a strong focus on the bank's own workings and
allows banks to self-monitor.'' \948\ One commenter indicated that a
comprehensive compliance program is a ``cornerstone of effective
corporate governance,'' but cautioned against placing ``undue
reliance'' on compliance programs.\949\ As discussed further below in
Parts IV.C.1. and IV.C.3., many commenters expressed concern about the
potential burdens of the proposed rule's compliance program
requirement, as well as the proposed requirement regarding quantitative
measurements. According to one commenter, the compliance burdens
associated with these requirements may dissuade a banking entity from
attempting to comply with the market-making exemption.\950\
---------------------------------------------------------------------------

    \947\ See Flynn & Fusselman; Morgan Stanley.
    \948\ See Flynn & Fusselman.
    \949\ See Occupy.
    \950\ See ICI (Feb. 2012).
---------------------------------------------------------------------------

c. Final Compliance Program Requirement
    Similar to the proposed exemption, the market-making exemption
adopted in the final rule requires that a banking entity establish and
implement, maintain, and enforce an internal compliance program
required by subpart D that is reasonably designed to ensure the banking
entity's compliance with the requirements of the market-making
exemption, including reasonably designed written policies and
procedures, internal controls, analysis, and independent testing.\951\
This provision further requires that the compliance program include
particular written policies and procedures, internal controls,
analysis, and independent testing identifying and addressing:
---------------------------------------------------------------------------

    \951\ The independent testing standard is discussed in more
detail in Part IV.C., which discusses the compliance program
requirement in Sec.  ----.20 of the final rule.
---------------------------------------------------------------------------

     The financial instruments each trading desk stands ready
to purchase and sell as a market maker;
     The actions the trading desk will take to demonstrably
reduce or otherwise significantly mitigate promptly the risks of its
financial exposure consistent with the required limits; the products,
instruments, and exposures each trading desk may use for risk
management purposes; the techniques and strategies each trading desk
may use to manage the risks of its market making-related activities and
inventory; and the process, strategies, and personnel responsible for
ensuring that the actions taken by the trading desk to mitigate these
risks are and continue to be effective;
     Limits for each trading desk, based on the nature and
amount of the trading desk's market making-related activities, that
address the factors prescribed by the near term customer demand
requirement of the final rule, on:
    [cir] The amount, types, and risks of its market-maker inventory;

    [cir] The amount, types, and risks of the products, instruments,
and exposures the trading desk uses for risk management purposes;
    [cir] Level of exposures to relevant risk factors arising from its
financial exposure; and
    [cir] Period of time a financial instrument may be held;
     Internal controls and ongoing monitoring and analysis of
each trading desk's compliance with its required limits; and
     Authorization procedures, including escalation procedures
that require review and approval of any trade that would exceed a
trading desk's limit(s), demonstrable analysis that the basis for any
temporary or permanent increase to a trading desk's limit(s) is
consistent with the requirements of Sec.  ----.4(b)(2)(ii) of the final
rule, and independent review (i.e., by risk managers and compliance
officers at the appropriate level independent of the trading desk) of
such demonstrable analysis and approval.\952\
---------------------------------------------------------------------------

    \952\ See final rule Sec.  ----.4(b)(2)(iii).
---------------------------------------------------------------------------

    The compliance program requirement in the proposed market-making
exemption did not include specific references to all the compliance
program elements now listed in the final rule. Instead, these elements
were generally included in the compliance requirements of Appendix C of
the proposed rule. The Agencies are moving certain of these
requirements into the market-making exemption to ensure that critical
components are made part of the compliance program for market making-
related activities. Further, placing these requirements within the
market-making exemption emphasizes the important role they play in
overall compliance with the exemption.\953\ Banking entities should
note that these compliance procedures must be established, implemented,
maintained, and enforced for each trading desk engaged in market
making-related activities under the final rule. Each of the
requirements in paragraphs (b)(2)(iii)(A) through (E) must be
appropriately tailored to the individual trading activities and
strategies of each trading desk on an ongoing basis.
---------------------------------------------------------------------------

    \953\ The Agencies note that a number of commenters requested
that the Agencies place a greater emphasis on inventory limits and
risk limits in the final exemption. See, e.g., Citigroup (suggesting
that the market-making exemption utilize risk limits that would be
set for each trading unit based on expected levels of customer
trading--estimated by looking to historical results, target product
and customer lists, and target market share--and an appropriate
amount of required inventory to support that level of customer
trading); Prof. Colesanti et al. (suggesting that the exemption
include, among other things, a bright-line threshold of the amount
of risk that can be retained (which cannot be in excess of the size
and type required for market making), positions limits, and limits
on holding periods); Sens. Merkley & Levin (Feb. 2012) (suggesting
the use of specific parameters for inventory levels, along with a
number of other criteria, to establish a safe harbor); SIFMA et al.
(Prop. Trading) (Feb. 2012) (recommending the use of risk limits in
combination with a guidance-based approach); Japanese Bankers Ass'n.
(suggesting that the rule set risk allowances for market making-
related activities based on required capital for such activities).
The Agencies are not establishing specific limits in the final rule,
as some commenters appeared to recommend, in recognition of the fact
that appropriate limits will differ based on a number of factors,
including the size of the market-making operation and the liquidity,
depth, and maturity of the market for the particular type(s) of
financial instruments in which the trading desk is permitted to
trade. See Sens. Merkley & Levin (Feb. 2012); Prof. Colesanti et al.
However, banking entities relying on the market-making exemption
must set limits and demonstrate how the specific limits and limit
methodologies they have chosen are reasonably designed to limit the
amount, types, and risks of the financial instruments in a trading
desk's market-maker inventory consistent with the reasonably
expected near term demands of the banking entity's clients,
customers, and counterparties, subject to the market and conditions
discussed above, and to commensurately control the desk's overall
financial exposure.
---------------------------------------------------------------------------

    As a threshold issue, the compliance program must identify the
products, instruments, and exposures the trading desk may trade as
market maker or for risk management purposes.\954\ Identifying the
relevant instruments in which a trading desk is permitted to trade will
facilitate monitoring and oversight of compliance with the exemption by
preventing an individual trader on a market-making desk from
establishing positions in instruments that are unrelated to the desk's
market-making function. Further, this identification of instruments
helps form the basis for the specific types of inventory and risk
limits that the banking entity must establish and is relevant to
considerations throughout the exemption regarding the liquidity, depth,
and maturity of the market for the relevant type of financial
instrument. The Agencies note that a banking entity should be able to
demonstrate the relationship between the instruments in which a trading
desk may act as market maker and the instruments the desk may use to
manage the risk of its market making-related activities and inventory
and why the instruments the desk may use to manage its risk
appropriately and effectively mitigate the risk of its market making-
related activities without generating an entirely new set of risks that
outweigh the risks that are being hedged.
---------------------------------------------------------------------------

    \954\ See final rule Sec.  ----.4(b)(2)(iii)(A) (requiring
written policies and procedures, internal controls, analysis, and
independent testing regarding the financial instruments each trading
desk stands ready to purchase and sell in accordance with Sec.  --
--.4(b)(2)(i) of the final rule); final rule Sec.  --
--.4(b)(2)(iii)(B) (requiring written policies and procedures,
internal controls, analysis, and independent testing regarding the
products, instruments, or exposures each trading desk may use for
risk management purposes).
---------------------------------------------------------------------------

    The final rule provides that a banking entity must establish an
appropriate risk management framework for each of its trading desks
that rely on the market-making exemption.\955\ This includes not only
the techniques and strategies that a trading desk may use to manage its
risk exposures, but also the actions the trading desk will take to
demonstrably reduce or otherwise significantly mitigate promptly the
risks of its financial exposures consistent with its required limits,
which are discussed in more detail below. While the Agencies do not
expect a trading desk to hedge all of the risks that arise from its
market making-related activities, the Agencies do expect each trading
desk to take appropriate steps consistent with market-making activities
to contain and limit risk exposures (such as by unwinding unneeded
positions) and to follow reasonable procedures to monitor the trading
desk's risk exposures (i.e., its financial exposure) and hedge risks of
its financial exposure to remain within its relevant risk limits.\956\
---------------------------------------------------------------------------

    \955\ This standard addresses issues raised by commenters
concerning: Certain language in proposed Appendix B regarding market
making-related risk management; the market making-related hedging
provision in Sec.  ----.4(b)(3) of the proposed rule; and, to some
extent, the proposed source of revenue requirement in Sec.  --
--.4(b)(2)(v) of the proposed rule. See Joint Proposal, 76 FR
68,960; CFTC Proposal, 77 FR 8439-8440; proposed rule Sec.  --
--.4(b)(3); Joint Proposal, 76 FR 68,873; CFTC Proposal, 77 FR 8358;
Wellington; Credit Suisse (Seidel); Morgan Stanley; PUC Texas;
CIEBA; SSgA (Feb. 2012); Alliance Bernstein; Investure; Invesco;
Japanese Bankers Ass'n.; SIFMA et al. (Prop. Trading) (Feb. 2012);
FTN; RBC; NYSE Euronext; MFA. As discussed in more detail above, a
number of commenters emphasized that market making-related
activities necessarily involve a certain amount of risk-taking to
provide ``immediacy'' to customers. See, e.g., Prof. Duffie; Morgan
Stanley; SIFMA et al. (Prop. Trading) (Feb. 2012). Commenters also
represented that the amount of risk a market maker needs to retain
may differ across asset classes and markets. See, e.g., Morgan
Stanley; Credit Suisse (Seidel). The Agencies believe that the
requirement we are adopting better recognizes that appropriate risk
management will tailor acceptable position, risk and inventory
limits based on the type(s) of financial instruments in which the
trading desk is permitted to trade and the liquidity, maturity, and
depth of the market for the relevant type of financial instrument.
    \956\ It may be more efficient for a banking entity to manage
some risks at a higher organizational level than the trading desk
level. As a result, a banking entity's written policies and
procedures may delegate the responsibility to mitigate specific
risks of the trading desk's financial exposure to an entity other
than the trading desk, including another organizational unit of the
banking entity or of an affiliate, provided that such organizational
unit of the banking entity or of an affiliate is identified in the
banking entity's written policies and procedures. Under these
circumstances, the other organizational unit of the banking entity
or of an affiliate must conduct such hedging activity in accordance
with the requirements of the hedging exemption in Sec.  ----.5 of
the final rule, including the documentation requirement in Sec.  --
--.5(c). As recognized in Part IV.A.4.d.4., hedging activity
conducted by a different organizational unit than the unit
responsible for the positions being hedged presents a greater risk
of evasion. Further, the risks being managed by a higher
organizational level than the trading desk may be generated by
trading desks engaged in market making-related activity or by
trading desks engaged in other permitted activities. Thus, it would
be inappropriate for such hedging activity to be conducted in
reliance on the market-making exemption.

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

    As discussed in Part IV.A.3.c.4.c., managing the risks associated
with maintaining a market-maker inventory that is appropriate to meet
the reasonably expected near-term demands of customers is an important
part of market making.\957\ The Agencies understand that, in the
context of market-making activities, inventory management includes
adjustment of the amount and types of market-maker inventory to meet
the reasonably expected near term demands of customers.\958\
Adjustments of the size and types of a financial exposure are also made
to reduce or mitigate the risks associated with financial instruments
held as part of a trading desk's market-maker inventory. A common
strategy in market making is to establish market-maker inventory in
anticipation of reasonably expected customer needs and then to reduce
that market-maker inventory over time as customer demand
materializes.\959\ If customer demand does not materialize, the market
maker addresses the risks associated with its market-maker inventory by
adjusting the amount or types of financial instruments in its inventory
as well as taking steps otherwise to mitigate the risk associated with
its inventory.
---------------------------------------------------------------------------

    \957\ See supra Part IV.A.3.c.2.c. (discussing the final near
term demand requirement).
    \958\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);
Credit Suisse (Seidel); Goldman (Prop. Trading); MFA; RBC.
    \959\ See, e.g., BoA; SIFMA et al. (Prop. Trading) (Feb. 2012);
Chamber (Feb. 2012).
---------------------------------------------------------------------------

    The Agencies recognize that, to provide effective intermediation
services, a trading desk engaged in permitted market making-related
activities retains a certain amount of risk arising from the positions
it holds in inventory and may hedge certain aspects of that risk. The
requirements in the final rule establish controls around a trading
desk's risk management activities, yet still recognize that a trading
desk engaged in market making-related activities may retain a certain
amount of risk in meeting the reasonably expected near term demands of
clients, customers, or counterparties. As the Agencies noted in the
proposal, where the purpose of a transaction is to hedge a market
making-related position, it would appear to be market making-related
activity of the type described in section 13(d)(1)(B) of the BHC
Act.\960\ The Agencies emphasize that the only risk management
activities that qualify for the market-making exemption--and that are
not subject to the hedging exemption--are risk management activities
conducted or directed by the trading desk in connection with its market
making-related activities and in conformance with the trading desk's
risk management policies and procedures.\961\ A trading desk engaged in
market making-related activities would be required to comply with the
hedging exemption or another available exemption for any risk
management or other activity that is not in conformance with the
trading desk's required market-making risk management policies and
procedures.
---------------------------------------------------------------------------

    \960\ See Joint Proposal, 76 FR 68,873; CFTC Proposal, 77 FR
8358.
    \961\ As discussed above, if a trading desk operating under the
market-making exemption directs a different organizational unit of
the banking entity or an affiliate to establish a hedge position on
the desk's behalf, then the other organizational unit may rely on
the market-making exemption to establish the hedge position as long
as: (i) The other organizational unit's hedging activity is
consistent with the trading desk's risk management policies and
procedures (e.g., the hedge instrument, technique, and strategy are
consistent with those identified in the trading desk's policies and
procedures); and (ii) the hedge position is attributed to the
financial exposure of the trading desk and is included in the
trading desk's daily profit and loss. If a different organizational
unit of the banking entity or of an affiliate establishes a hedge
for the trading desk's financial exposure based on its own
determination, or if such position was not established in accordance
with the trading desk's required procedures or was included in that
other organizational unit's financial exposure and/or daily profit
and loss, then that hedge position must be established in compliance
with the hedging exemption in Sec.  ----.5 of the rule, including
the documentation requirement in Sec.  ----.5(c). See supra Part
IV.A.3.c.1.c.ii.
---------------------------------------------------------------------------

    A banking entity's written policies and procedures, internal
controls, analysis, and independent testing identifying and addressing
the products, instruments, or exposures and the techniques and
strategies that may be used by each trading desk to manage the risks of
its market making-related activities and inventory must cover both how
the trading desk may establish hedges and how such hedges are removed
once the risk they were mitigating is unwound. With respect to
establishing positions that hedge or otherwise mitigate the risk(s) of
market making-related positions held by the trading desk, the written
policies and procedures may consider the natural hedging and
diversification that occurs in an aggregation of long and short
positions in financial instruments for which the trading desk is a
market maker,\962\ as it documents its specific risk-mitigating
strategies that use instruments for which the desk is a market maker or
instruments for which the desk is not a market maker. Further, the
written policies and procedures identifying and addressing permissible
hedging techniques and strategies must address the circumstances under
which the trading desk may be permitted to engage in anticipatory
hedging. Like the proposed rule's hedging exemption, a trading desk may
establish an anticipatory hedge position before it becomes exposed to a
risk that it is highly likely to become exposed to, provided there is a
sound risk management rationale for establishing such an anticipatory
hedge position.\963\ For example, a trading desk may hedge against
specific positions promised to customers, such as volume-weighted
average price (``VWAP'') orders or large block trades, to facilitate
the customer trade.\964\ The amount of time that an anticipatory hedge
may precede the establishment of the position to be hedged will depend
on market factors, such as the liquidity of the hedging position.
---------------------------------------------------------------------------

    \962\ For example, this may occur if a U.S. corporate bond
trading desk acquires a $100 million long position in the corporate
bonds of one issuer from clients, customers, or counterparties and
separately acquires a $50 million short position in another issuer
in the same market sector in reasonable expectation of near term
demand of clients, customers, or counterparties. Although both
positions were acquired to facilitate customer demand, the positions
may also naturally hedge each other, to some extent.
    \963\ See Joint Proposal, 76 FR 68,875; CFTC Proposal, 77 FR
8361.
    \964\ Two commenters recommended that banking entities be
permitted to establish hedges prior to acquiring the underlying risk
exposure under these circumstances. See Credit Suisse (Seidel); BoA.
---------------------------------------------------------------------------

    Written policies and procedures, internal controls, analysis, and
independent testing established pursuant to the final rule identifying
and addressing permissible hedging techniques and strategies should be
designed to prevent a trading desk from over-hedging its market-maker
inventory or financial exposure. Over-hedging would occur if, for
example, a trading desk established a position in a financial
instrument for the purported purpose of reducing a risk associated with
one or more market-making positions when, in fact, that risk had
already been mitigated to the full extent possible. Over-hedging
results in a new risk exposure that is unrelated to market-making
activities and, thus, is not permitted under the market-making
exemption.

    A trading desk's financial exposure generally would not be
considered to be consistent with market making-related activities to
the extent the trading desk is engaged in hedging activities that are
inconsistent with the management of identifiable risks in its market-
maker inventory or maintains significant hedge positions after the
underlying risk(s) of the market-maker inventory have been unwound. A
banking entity's written policies and procedures, internal controls,
analysis, and independent testing regarding the trading desk's
permissible hedging techniques and strategies must be designed to
prevent a trading desk from engaging in over-hedging or maintaining
hedge positions after they are no longer needed.\965\ Further, the
compliance program must provide for the process and personnel
responsible for ensuring that the actions taken by the trading desk to
mitigate the risks of its market making-related activities are and
continue to be effective, which would include monitoring for and
addressing any scenarios where a trading desk may be engaged in over-
hedging or maintaining unnecessary hedge positions or new significant
risks have been introduced by the hedging activity.
---------------------------------------------------------------------------

    \965\ See final rule Sec.  ----.4(b)(2)(iii)(B).
---------------------------------------------------------------------------

    As a result of these limitations, the size and risks of the trading
desk's hedging positions are naturally constrained by the size and
risks of its market-maker inventory, which must be designed not to
exceed the reasonably expected near term demands of clients, customers,
or counterparties, as well as by the risk limits and controls
established under the final rule. This ultimately constrains a trading
desk's overall financial exposure since such position can only contain
positions, risks, and exposures related to the market-maker inventory
that are designed to meet current or near term customer demand and
positions, risks and exposures designed to mitigate the risks in
accordance with the limits previously established for the trading desk.
    The written policies and procedures identifying and addressing a
trading desk's hedging techniques and strategies also must describe how
and under what timeframe a trading desk must remove hedge positions
once the underlying risk exposure is unwound. Similarly, the compliance
program established by the banking entity to specify and control the
trading desk's hedging activities in accordance with the final rule
must be designed to prevent a trading desk from purposefully or
inadvertently transforming its positions taken to manage the risk of
its market-maker inventory under the exemption into what would
otherwise be considered prohibited proprietary trading.
    Moreover, the compliance program must provide for the process and
personnel responsible for ensuring that the actions taken by the
trading desk to mitigate the risks of its market making-related
activities and inventory--including the instruments, techniques, and
strategies used for risk management purposes--are and continue to be
effective. This includes ensuring that hedges taken in the context of
market making-related activities continue to be effective and that
positions taken to manage the risks of the trading desk's market-maker
inventory are not purposefully or inadvertently transformed into what
would otherwise be considered prohibited proprietary trading. If a
banking entity's monitoring procedures find that a trading desk's risk
management procedures are not effective, such deficiencies must be
promptly escalated and remedied in accordance with the banking entity's
escalation procedures. A banking entity's written policies and
procedures must set forth the process for determining the circumstances
under which a trading desk's risk management strategies may be
modified. In addition, risk management techniques and strategies
developed and used by a trading desk must be independently tested or
verified by management separate from the trading desk.
    To control and limit the amount and types of financial instruments
and risks that a trading desk may hold in connection with its market
making-related activities, a banking entity must establish, implement,
maintain, and enforce reasonably designed written policies and
procedures, internal controls, analysis, and independent testing
identifying and addressing specific limits on a trading desk's market-
maker inventory, risk management positions, and financial exposure. In
particular, the compliance program must establish limits for each
trading desk, based on the nature and amount of its market making-
related activities (including the factors prescribed by the near term
customer demand requirement), on the amount, types, and risks of its
market-maker inventory, the amount, types, and risks of the products,
instruments, and exposures the trading desk may use for risk management
purposes, the level of exposures to relevant risk factors arising from
its financial exposure, and the period of time a financial instrument
may be held.\966\ The limits would be set, as appropriate, and
supported by an analysis for specific types of financial instruments,
levels of risk, and duration of holdings, which would also be required
by the compliance appendix. This approach will build on existing risk
management infrastructure for market-making activities that subject
traders to a variety of internal, predefined limits.\967\ Each of these
limits is independent of the others, and a trading desk must maintain
its aggregated market-making position within each of these limits,
including by taking action to bring the trading desk into compliance
with the limits as promptly as possible after the limit is
exceeded.\968\ For example, if changing market conditions cause an
increase in one or more risks within the trading desk's financial
exposure and that increased risk causes the desk to exceed one or more
of its limits, the trading desk must take prompt action to reduce its
risk exposure (either by hedging the risk or unwinding its existing
positions) or receive approval of a temporary or permanent increase to
its limit through the required escalation procedures.
---------------------------------------------------------------------------

    \966\ See final rule Sec.  ----.4(b)(2)(iii)(C).
    \967\ See, e.g., Citigroup (Feb. 2012) (noting that its
suggested approach to implementing the market-making exemption,
which would focus on risk limits and risk architecture, would build
on existing risk limits and risk management systems already present
in institutions).
    \968\ See final rule Sec.  ----.4(b)(2)(iv).
---------------------------------------------------------------------------

    The Agencies recognize that trading desks' limits will differ
across asset classes and acknowledge that trading desks engaged in
market making-related activities in less liquid asset classes, such as
corporate bonds, certain derivatives, and securitized products, may
require different inventory, risk exposure, and holding period limits
than trading desks engaged in market making-related activities in more
liquid financial instruments, such as certain listed equity securities.
Moreover, the types of risk factors for which limits are established
should not be limited solely to market risk factors. Instead, such
limits should also account for all risk factors that arise from the
types of financial instruments in which the trading desk is permitted
to trade. In addition, these limits should be sufficiently granular and
focused on the particular types of financial instruments in which the
desk may trade. For example, a trading desk that makes a market in
derivatives would have exposures to counterparty risk, among others,
and would need to have appropriate limits on such risk. Other types of
limits that may be relevant for a trading desk include, among others,

position limits, sector limits, and geographic limits.
    A banking entity must have a reasonable basis for the limits it
establishes for a trading desk and must have a robust procedure for
analyzing, establishing, and monitoring limits, as well as appropriate
escalation procedures.\969\ Among other things, the banking entity's
compliance program must provide for: (i) Written policies and
procedures and internal controls establishing and monitoring specific
limits for each trading desk; and (ii) analysis regarding how and why
these limits are determined to be appropriate and consistent with the
nature and amount of the desk's market making-related activities,
including considerations related to the near term customer demand
requirement. In making these determinations, a banking entity should
take into account and be consistent with the type(s) of financial
instruments the desk is permitted to trade, the desk's trading and risk
management activities and strategies, the history and experience of the
desk, and the historical profile of the desk's near term customer
demand and market and other factors that may impact the reasonably
expected near term demands of customers.
---------------------------------------------------------------------------

    \969\ See final rule Sec.  ----.4(b)(2)(iii)(C).
---------------------------------------------------------------------------

    The limits established by a banking entity should generally reflect
the amount and types of inventory and risk that a trading desk holds to
meet the reasonably expected near term demands of clients, customers,
or counterparties. As discussed above, while the trading desk's market-
maker inventory is directly limited by the reasonably expected near
term demands of customers, the positions managed by the trading desk
outside of its market-maker inventory are similarly constrained by the
near term demand requirement because they must be designed to manage
the risks of the market-maker inventory in accordance with the desk's
risk management procedures. As a result, the trading desk's risk
management positions and aggregate financial exposure are also limited
by the current and reasonably expected near term demands of customers.
A trading desk's market-maker inventory, risk management positions, or
financial exposure would not, however, be permissible under the market-
making exemption merely because the market-maker inventory, risk
management positions, or financial exposure happens to be within the
desk's prescribed limits.\970\
---------------------------------------------------------------------------

    \970\ For example, if a U.S. corporate bond trading desk has a
prescribed limit of $200 million net exposure to any single sector
of related issuers, the desk's limits may permit it to acquire a net
economic exposure of $400 million long to issuer ABC and a net
economic exposure of $300 million short to issuer XYZ, where ABC and
XYZ are in the same sector. This is because the trading desk's net
exposure to the sector would only be $100 million, which is within
its limits. Even though the net exposure to this sector is within
the trading desk's prescribed limits, the desk would still need to
be able to demonstrate how its net exposure of $400 million long to
issuer ABC and $300 million short to issuer XYZ is related to
customer demand.
---------------------------------------------------------------------------

    In addition, a banking entity must establish internal controls and
ongoing monitoring and analysis of each trading desk's compliance with
its limits, including the frequency, nature, and extent of a trading
desk exceeding its limits and patterns regarding the portions of the
trading desk's limits that are accounted for by the trading desk's
activity.\971\ This may include the use of management and exception
reports. Moreover, the compliance program must set forth a process for
determining the circumstances under which a trading desk's limits may
be modified on a temporary or permanent basis (e.g., due to market
changes or modifications to the trading desk's strategy).\972\ This
process must cover potential scenarios when a trading desk's limits
should be raised, as well as potential scenarios when a trading desk's
limits should be lowered. For example, if a trading desk experiences
reduced customer demand over a period of time, that trading desk's
limits should be decreased to address the factors prescribed by the
near term demand requirement.
---------------------------------------------------------------------------

    \971\ See final rule Sec.  ----.4(b)(2)(iii)(D).
    \972\ For example, a banking entity may determine to permit
temporary, short-term increases to a trading desk's risk limits due
to an increase in short-term credit spreads or in response to
volatility in instruments in which the trading desk makes a market,
provided the increased limit is consistent with the reasonably
expected near term demands of clients, customers, or counterparties.
As noted above, other potential circumstances that could warrant
changes to a trading desk's limits include: A change in the pattern
of customer needs, adjustments to the market maker's business model
(e.g., new entrants or existing market makers trying to expand or
contract their market share), or changes in market conditions. See
supra note 932 and accompanying text.
---------------------------------------------------------------------------

    A banking entity's compliance program must also include escalation
procedures that require review and approval of any trade that would
exceed one or more of a trading desk's limits, demonstrable analysis
that the basis for any temporary or permanent increase to one or more
of a trading desk's limits is consistent with the near term customer
demand requirement, and independent review of such demonstrable
analysis and approval of any increase to one or more of a trading
desk's limits.\973\ Thus, in order to increase a limit of a trading
desk--on either a temporary or permanent basis--there must be an
analysis of why such increase would be appropriate based on the
reasonably expected near term demands of clients, customers, or
counterparties, including the factors identified in Sec.  --
--.4(b)(2)(ii) of the final rule, which must be independently reviewed.
A banking entity also must maintain documentation and records with
respect to these elements, consistent with the requirement of Sec.  --
--.20(b)(6).
---------------------------------------------------------------------------

    \973\ See final rule Sec.  ----.4(b)(2)(iii)(E).
---------------------------------------------------------------------------

    As already discussed, commenters have represented that the
compliance costs associated with the proposed rule, including the
compliance program and metrics requirements, may be significant and
``may dissuade a banking entity from attempting to comply with the
market making-related activities exemption.''\974\ The Agencies believe
that a robust compliance program is necessary to ensure adherence to
the rule and to prevent evasion, although, as discussed in Part
IV.C.3., the Agencies are adopting a more tailored set of quantitative
measurements to better focus on those that are most germane to
evaluating market making-related activity. The Agencies acknowledge
that the compliance program requirements for the market-making
exemption, including reasonably designed written policies and
procedures, internal controls, analysis, and independent testing,
represent a new regulatory requirement for banking entities and the
Agencies have thus been mindful that it may impose significant costs
and may cause a banking entity to reconsider whether to conduct market
making-related activities. Despite the potential costs of the
compliance program, the Agencies believe they are warranted to ensure
that the goals of the rule and statute will be met, such as promoting
the safety and soundness of banking entities and the financial
stability of the United States.
---------------------------------------------------------------------------

    \974\ See ICI (Feb. 2012).
---------------------------------------------------------------------------

4. Market Making-Related Hedging
a. Proposed Treatment of Market Making-Related Hedging
    In the proposal, certain hedging transactions related to market
making were considered to be made in connection with a banking entity's
market making-related activity for purposes of the market-making
exemption. The Agencies explained that where the purpose of a
transaction is to hedge a market making-related position, it would
appear to be market making-related activity of the type described in

section 13(d)(1)(B) of the BHC Act.\975\ To qualify for the market-
making exemption, a hedging transaction would have been required to
meet certain requirements under Sec.  ----.4(b)(3) of the proposed
rule. This provision required that the purchase or sale of a financial
instrument: (i) Be conducted to reduce the specific risks to the
banking entity in connection with and related to individual or
aggregated positions, contracts, or other holdings acquired pursuant to
the market-making exemption; and (ii) meet the criteria specified in
Sec.  ----.5(b) of the proposed hedging exemption and, where
applicable, Sec.  ----.5(c) of the proposal.\976\ In the proposal, the
Agencies noted that a market maker may often make a market in one type
of financial instrument and hedge its activities using different
financial instruments in which it does not make a market. The Agencies
stated that this type of hedging transaction would meet the terms of
the market-making exemption if the hedging transaction met the
requirements of Sec.  ----.4(b)(3) of the proposed rule.\977\
---------------------------------------------------------------------------

    \975\ See Joint Proposal, 76 FR 68,873; CFTC Proposal, 77 FR
8358.
    \976\ See proposed rule Sec.  ----.4(b)(3); Joint Proposal, 76
FR 68,873; CFTC Proposal, 77 FR 8358.
    \977\ See Joint Proposal, 76 FR 68,870 n.146; CFTC Proposal, 77
FR 8356 n.152.
---------------------------------------------------------------------------

b. Comments on the Proposed Treatment of Market Making-Related Hedging
    Several commenters recommended that the proposed market-making
exemption be modified to establish a more permissive standard for
market maker hedging.\978\ A few of these commenters stated that,
rather than applying the standards of the risk-mitigating hedging
exemption to market maker hedging, a market maker's hedge position
should be permitted as long as it is designed to mitigate the risk
associated with positions acquired through permitted market making-
related activities.\979\ Other commenters emphasized the need for
flexibility to permit a market maker to choose the most effective
hedge.\980\ In general, these commenters expressed concern that
limitations on hedging market making-related positions may cause a
reduction in liquidity, wider spreads, or increased risk and trading
costs for market makers.\981\ For example, one commenter stated that
``[t]he ability of market makers to freely offset or hedge positions is
what, in most cases, makes them willing to buy and sell [financial
instruments] to and from customers, clients or counterparties,'' so
``[a]ny impediment to hedging market making-related positions will
decrease the willingness of banking entities to make markets and,
accordingly, reduce liquidity in the marketplace.'' \982\
---------------------------------------------------------------------------

    \978\ See, e.g., Japanese Bankers Ass'n.; SIFMA et al. (Prop.
Trading) (Feb. 2012); Credit Suisse (Seidel); FTN; RBC; NYSE
Euronext; MFA. These comments are addressed in Part IV.A.3.c.4.c.,
infra.
    \979\ See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC. See
also FTN (stating that the principal requirement for such hedges
should be that they reduce the risk of market making).
    \980\ See NYSE Euronext (stating that the best hedge sometimes
involves a variety of complex and dynamic transactions over the time
in which an asset is held, which may fall outside the parameters of
the exemption); MFA; JPMC.
    \981\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit
Suisse (Seidel); NYSE Euronext; MFA; Japanese Bankers Ass'n.; RBC.
    \982\ RBC.
---------------------------------------------------------------------------

    In addition, some commenters expressed concern that certain
requirements in the proposed hedging exemption may result in a
reduction in market-making activities under certain circumstances.\983\
For example, one commenter expressed concern that the proposed hedging
exemption would require a banking entity to identify and tag hedging
transactions when hedges in a particular asset class take place
alongside a trading desk's customer flow trading and inventory
management in that same asset class.\984\ Further, a few commenters
represented that the proposed reasonable correlation requirement in the
hedging exemption could impact market making by discouraging market
makers from entering into customer transactions that do not have a
direct hedge \985\ or making it more difficult for market makers to
cost-effectively hedge the fixed income securities they hold in
inventory, including hedging such inventory positions on a portfolio
basis.\986\
---------------------------------------------------------------------------

    \983\ See BoA; SIFMA (Asset Mgmt.) (Feb. 2012).
    \984\ See Goldman (Prop. Trading).
    \985\ See BoA.
    \986\ See SIFMA (Asset Mgmt.) (Feb. 2012).
---------------------------------------------------------------------------

    One commenter, however, stated that the proposed approach is
effective.\987\ Another commenter indicated that it is confusing to
include hedging within the market-making exemption and suggested that a
market maker be required to rely on the hedging exemption under Sec.
----.5 of the proposed rule for its hedging activity.\988\
---------------------------------------------------------------------------

    \987\ See Alfred Brock.
    \988\ See Occupy.
---------------------------------------------------------------------------

    As noted above in the discussion of comments on the proposed source
of revenue requirement, a number of commenters expressed concern that
the proposed rule assumed that there are effective, or perfect, hedges
for all market making-related positions.\989\ Another commenter stated
that market makers should be required to hedge whenever an inventory
imbalance arises, and the absence of a hedge in such circumstances may
evidence prohibited proprietary trading.\990\
---------------------------------------------------------------------------

    \989\ See infra notes 1068 to 1070 and accompanying text.
    \990\ See Public Citizen.
---------------------------------------------------------------------------

c. Treatment of Market Making-Related Hedging in the Final Rule
    Unlike the proposed rule, the final rule does not require that
market making-related hedging activities separately comply with the
requirements found in the risk-mitigating hedging exemption if
conducted or directed by the same trading desk conducting the market-
making activity. Instead, the Agencies are including requirements for
market making-related hedging activities within the market-making
exemption in response to comments.\991\ As discussed above, a trading
desk's compliance program must include written policies and procedures,
internal controls, independent testing and analysis identifying and
addressing the products, instruments, exposures, techniques, and
strategies a trading desk may use to manage the risks of its market
making-related activities, as well as the actions the trading desk will
take to demonstrably reduce or otherwise significant mitigate the risks
of its financial exposure consistent with its required limits.\992\ The
Agencies believe this approach addresses commenters' concerns that
limitations on hedging market making-related positions may cause a
reduction in liquidity, wider spreads, or increased risk and trading
costs for market makers because it allows banking entities to determine
how best to manage the risks of trading desks' market making-related
activities through reasonable policies and procedures, internal
controls, independent testing, and analysis, rather than requiring
compliance with the specific requirements of the hedging
exemption.\993\ Further, this approach addresses commenters' concerns
about the impact of certain requirements of the hedging exemption on
market making-related activities.\994\
---------------------------------------------------------------------------

    \991\ See, e.g., Japanese Bankers Ass'n.; SIFMA et al. (Prop.
Trading) (Feb. 2012); Credit Suisse (Seidel); FTN; RBC; NYSE
Euronext; MFA.
    \992\ See final rule Sec.  ----.4(b)(2)(iii)(B); supra Part
IV.A.3.c.3.c.
    \993\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit
Suisse (Seidel); NYSE Euronext; MFA; Japanese Bankers Ass'n.; RBC.
    \994\ See BoA; SIFMA (Asset Mgmt.) (Feb. 2012); Goldman (Prop.
Trading).
---------------------------------------------------------------------------

    The Agencies believe it is consistent with the statute's reference
to ``market making-related'' activities to permit

market making-related hedging activities under this exemption. In
addition, the Agencies believe it is appropriate to require a trading
desk to appropriately manage its risks, consistent with its risk
management procedures and limits, because management of risk is a key
factor that distinguishes permitted market making-related activity from
impermissible proprietary trading. As noted in the proposal, while ``a
market maker attempts to eliminate some [of the risks arising from] its
retained principal positions and risks by hedging or otherwise managing
those risks [ ], a proprietary trader seeks to capitalize on those
risks, and generally only hedges or manages a portion of those risks
when doing so would improve the potential profitability of the risk it
retains.'' \995\
---------------------------------------------------------------------------

    \995\ See Joint Proposal, 76 FR 68,961.
---------------------------------------------------------------------------

    The Agencies recognize that some banking entities may manage the
risks associated with market making at a different level than the
individual trading desk.\996\ While this risk management activity is
not permitted under the market-making exemption, it may be permitted
under the hedging exemption, provided the requirements of that
exemption are met. Thus, the Agencies believe banking entities will
continue to have options available that allow them to efficiently hedge
the risks arising from their market-making operations. Nevertheless,
the Agencies understand that this rule will result in additional
documentation or other potential burdens for market making-related
hedging activity that is not conducted by the trading desk responsible
for the market-making positions being hedged.\997\ As discussed in Part
IV.A.4.d.4., hedging conducted by a different organizational unit than
the trading desk that is responsible for the underlying positions
presents an increased risk of evasion, so the Agencies believe it is
appropriate for such hedging activity to be required to comply with the
hedging exemption, including the associated documentation requirement.
---------------------------------------------------------------------------

    \996\ See, e.g., letter from JPMC (stating that, to minimize
risk management costs, firms commonly organize their market-making
activities so that risks delivered to client-facing desks are
aggregated and passed by means of internal transactions to a single
utility desk and suggesting this be recognized as permitted market
making-related behavior).
    \997\ See final rule Sec.  ----.5(c).
---------------------------------------------------------------------------

5. Compensation Requirement
a. Proposed Compensation Requirement
    Section ----.4(b)(2)(vii) of the proposed market-making exemption
would have required that the compensation arrangements of persons
performing market making-related activities at the banking entity be
designed not to reward proprietary risk-taking.\998\ In the proposal,
the Agencies noted that activities for which a banking entity has
established a compensation incentive structure that rewards speculation
in, and appreciation of, the market value of a financial instrument
position held in inventory, rather than success in providing effective
and timely intermediation and liquidity services to customers, would be
inconsistent with the proposed market-making exemption.
---------------------------------------------------------------------------

    \998\ See proposed rule Sec.  ----.4(b)(2)(vii).
---------------------------------------------------------------------------

    The Agencies stated that under the proposed rule, a banking entity
relying on the market-making exemption should provide compensation
incentives that primarily reward customer revenues and effective
customer service, not proprietary risk-taking. However, the Agencies
noted that a banking entity relying on the proposed market-making
exemption would be able to appropriately take into account revenues
resulting from movements in the price of principal positions to the
extent that such revenues reflect the effectiveness with which
personnel have managed principal risk retained.\999\
---------------------------------------------------------------------------

    \999\ See Joint Proposal, 76 FR 68,872; CFTC Proposal, 77 FR
8358.
---------------------------------------------------------------------------

b. Comments Regarding the Proposed Compensation Requirement
    Several commenters recommended certain revisions to the proposed
compensation requirement.\1000\ Two commenters stated that the proposed
requirement is effective,\1001\ while one commenter stated that it
should be removed from the rule.\1002\ Moreover, in addressing this
proposed requirement, commenters provided views on: identifiable
characteristics of compensation arrangements that incentivize
prohibited proprietary trading,\1003\ methods of monitoring compliance
with this requirement,\1004\ and potential negative incentives or
outcomes this requirement could cause.\1005\
---------------------------------------------------------------------------

    \1000\ See Prof. Duffie; SIFMA et al. (Prop. Trading) (Feb.
2012); John Reed; Credit Suisse (Seidel); JPMC; Morgan Stanley;
Better Markets (Feb. 2012); Johnson & Prof. Stiglitz; Occupy; AFR et
al. (Feb. 2012); Public Citizen.
    \1001\ See FTN; Alfred Brock.
    \1002\ See Japanese Bankers Ass'n.
    \1003\ See Occupy.
    \1004\ See Occupy; Goldman (Prop. Trading).
    \1005\ See AllianceBernstein; Prof. Duffie; Investure; STANY;
Chamber (Dec. 2011).
---------------------------------------------------------------------------

    With respect to suggested modifications to this requirement, a few
commenters suggested that a market maker's compensation should be
subject to additional limitations.\1006\ For example, two commenters
stated that compensation should be restricted to particular sources,
such as fees, commissions, and spreads.\1007\ One commenter suggested
that compensation should not be symmetrical between gains and losses
and, further, that trading gains reflecting an unusually high variance
in position values should either not be reflected in compensation and
bonuses or should be less reflected than other gains and losses.\1008\
Another commenter recommended that the Agencies remove ``designed''
from the rule text and provide greater clarity about how a banking
entity's compensation regime must be structured.\1009\ Moreover, a
number of commenters stated that compensation should be vested for a
period of time, such as until the trader's market making positions have
been fully unwound and are no longer in the banking entity's
inventory.\1010\ As one commenter explained, such a requirement would
discourage traders from carrying inventory and encourage them to get
out of positions as soon as possible.\1011\ Some commenters also
recommended that compensation be risk adjusted.\1012\
---------------------------------------------------------------------------

    \1006\ See Better Markets (Feb. 2012); Public Citizen; AFR et
al. (Feb. 2012); Occupy; John Reed; AFR et al. (Feb. 2012); Johnson
& Prof. Stiglitz; Prof. Duffie; Sens. Merkley & Levin (Feb. 2012).
These comments are addressed in note 1027, infra.
    \1007\ See Better Markets (Feb. 2012); Public Citizen.
    \1008\ See AFR et al. (Feb. 2012)
    \1009\ See Occupy.
    \1010\ See John Reed; AFR et al. (Feb. 2012); Johnson & Prof.
Stiglitz; Prof. Duffie (``A trader's incentives for risk taking can
be held in check by vesting incentive-based compensation over a
substantial period of time. Pending compensation can thus be
forfeited if a trader's negligence causes substantial losses or if
his or her employer fails.''); Sens. Merkley & Levin (Feb. 2012).
    \1011\ See John Reed.
    \1012\ See Johnson & Prof. Stiglitz; John Reed; Sens. Merkley &
Levin (Feb. 2012).
---------------------------------------------------------------------------

    A few commenters indicated that the proposed approach may be too
restrictive.\1013\ Two of these commenters stated that the compensation
requirement should instead be set forth as guidance in Appendix
B.\1014\ In addition, two commenters requested that the Agencies
clarify that compensation arrangements must be designed not to reward
prohibited proprietary risk-taking. These commenters were concerned the
proposed approach may restrict a banking entity's ability to provide
compensation for permitted activities,

which also involve proprietary trading.\1015\
---------------------------------------------------------------------------

    \1013\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC;
Morgan Stanley.
    \1014\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.
    \1015\ See Morgan Stanley; SIFMA et al. (Prop. Trading) (Feb.
2012). The Agencies respond to these comments in note 1026 and its
accompanying text, infra.
---------------------------------------------------------------------------

    Two commenters discussed identifiable characteristics of
compensation arrangements that clearly incentivize prohibited
proprietary trading.\1016\ For example, one commenter stated that
rewarding pure profit and loss, without consideration for the risk that
was assumed to capture it, is an identifiable characteristic of an
arrangement that incentivizes proprietary risk-taking.\1017\ For
purposes of monitoring and ensuring compliance with this requirement,
one commenter noted that existing Board regulations for systemically
important banking entities require comprehensive firm-wide policies
that determine compensation. This commenter stated that those
regulations, along with appropriately calibrated metrics, should ensure
that compensation arrangements are not designed to reward prohibited
proprietary risk-taking.\1018\ For similar purposes, another commenter
suggested that compensation incentives should be based on a metric that
meaningfully accounts for the risk underlying profitability.\1019\
---------------------------------------------------------------------------

    \1016\ See Occupy; Alfred Brock.
    \1017\ See Occupy. The Agencies respond to this comment in Part
IV.A.3.c.5.c., infra.
    \1018\ See Goldman (Prop. Trading).
    \1019\ See Occupy.
---------------------------------------------------------------------------

    Certain commenters expressed concern that the proposed compensation
requirement could incentivize market makers to act in a way that would
not be beneficial to customers or market liquidity.\1020\ For example,
two commenters expressed concern that the requirement could cause
market makers to widen their spreads or charge higher fees because
their personal compensation depends on these factors.\1021\ One
commenter stated that the proposed requirement could dampen traders'
incentives and discretion and may make market makers less likely to
accept trades involving significant increases in risk or profit.\1022\
Another commenter expressed the view that profitability-based
compensation arrangements encourage traders to exercise due care
because such arrangements create incentives to avoid losses.\1023\
Finally, one commenter stated that compliance with the proposed
requirement may be difficult or impossible if the Agencies do not take
into account the incentive-based compensation rulemaking.\1024\
---------------------------------------------------------------------------

    \1020\ See AllianceBernstein; Investure; Prof. Duffie; STANY.