This issue is addressed in note 1027, infra.
    \1021\ See AllianceBernstein; Investure.
    \1022\ See Prof. Duffie.
    \1023\ See STANY.
    \1024\ See Chamber (Dec. 2011).
---------------------------------------------------------------------------

c. Final Compensation Requirement
    Similar to the proposed rule, the market-making exemption requires
that the compensation arrangements of persons performing the banking
entity's market making-related activities, as described in the
exemption, are designed not to reward or incentivize prohibited
proprietary trading.\1025\ The language of the final compensation
requirement has been modified in response to comments expressing
concern about the proposed language regarding ``proprietary risk-
taking.'' \1026\ The Agencies note that the Agencies do not intend to
preclude an employee of a market-making desk from being compensated for
successful market making, which involves some risk-taking.
---------------------------------------------------------------------------

    \1025\ See final rule Sec.  ----.4(b)(2)(v).
    \1026\ See Morgan Stanley; SIFMA et al. (Prop. Trading) (Feb.
2012).
---------------------------------------------------------------------------

    The Agencies continue to hold the view that activities for which a
banking entity has established a compensation incentive structure that
rewards speculation in, and appreciation of, the market value of a
position held in inventory, rather than use of that inventory to
successfully provide effective and timely intermediation and liquidity
services to customers, are inconsistent with permitted market making-
related activities. Although a banking entity relying on the market-
making exemption may appropriately take into account revenues resulting
from movements in the price of principal positions to the extent that
such revenues reflect the effectiveness with which personnel have
managed retained principal risk, a banking entity relying on the
market-making exemption should provide compensation incentives that
primarily reward customer revenues and effective customer service, not
prohibited proprietary trading.\1027\ For example, a compensation plan
based purely on net profit and loss with no consideration for inventory
control or risk undertaken to achieve those profits would not be
consistent with the market-making exemption.
---------------------------------------------------------------------------

    \1027\ Because the Agencies are not limiting a market maker's
compensation to specific sources, such as fees, commissions, and
bid-ask spreads, as recommended by a few commenters, the Agencies do
not believe the compensation requirement in the final rule will
incentivize market makers to widen their quoted spreads or charge
higher fees and commissions, as suggested by certain other
commenters. See Better Markets (Feb. 2012); Public Citizen;
AllianceBernstein; Investure. In addition, the Agencies note that an
approach requiring revenue from fees, commissions, and bid-ask
spreads to be fully distinguished from revenue from price
appreciation can raise certain practical difficulties, as discussed
in Part IV.A.3.c.7. The Agencies also are not requiring compensation
to be vested for a period of time, as recommended by some commenters
to reduce traders' incentives for undue risk-taking. The Agencies
believe the final rule includes sufficient controls around risk-
taking activity without a compensation vesting requirement. See John
Reed; AFR et al. (Feb. 2012); Johnson & Prof. Stiglitz; Prof.
Duffie; Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

6. Registration Requirement
a. Proposed Registration Requirement
    Under Sec.  ----.4(b)(2)(iv) of the proposed rule, a banking entity
relying on the market-making exemption with respect to trading in
securities or certain derivatives would be required to be appropriately
registered as a securities dealer, swap dealer, or security-based swap
dealer, or exempt from registration or excluded from regulation as such
type of dealer, under applicable securities or commodities laws.
Further, if the banking entity was engaged in the business of a
securities dealer, swap dealer, or security-based swap dealer outside
the United States in a manner for which no U.S. registration is
required, the banking entity would be required to be subject to
substantive regulation of its dealing business in the jurisdiction in
which the business is located.\1028\
---------------------------------------------------------------------------

    \1028\ See proposed rule Sec.  ----.4(b)(2)(iv); Joint Proposal,
76 FR 68,872; CFTC Proposal, 77 FR 8357-8358.
---------------------------------------------------------------------------

b. Comments on the Proposed Registration Requirement
    A few commenters stated that the proposed dealer registration
requirement is effective.\1029\ However, a number of commenters opposed
the proposed dealer registration requirement in whole or in part.\1030\
Commenters' primary concern with the requirement appeared to be its
application to market making-related activities outside of the United
States for which no U.S. registration is required.\1031\ For example,
several commenters stated that many non-U.S. markets do not provide
substantive regulation of dealers for all asset classes.\1032\ In
addition, two

commenters stated that booking entities may be able to rely on intra-
group exemptions under local law rather than carrying dealer
registrations, or a banking entity may execute customer trades through
an international dealer but book the position in a non-dealer entity
for capital adequacy and risk management purposes.\1033\ Several of
these commenters requested, at a minimum, that the dealer registration
requirement not apply to dealers in non-U.S. jurisdictions.\1034\
---------------------------------------------------------------------------

    \1029\ See Occupy; Alfred Brock.
    \1030\ See SIFMA et al. (Prop. Trading) (Feb. 2012) (stating
that if the requirement is not removed from the rule, then it should
only be an indicative factor of market making); Morgan Stanley;
Goldman (Prop. Trading); ISDA (Feb. 2012).
    \1031\ See Goldman (Prop. Trading); Morgan Stanley; RBC; SIFMA
et al. (Prop. Trading) (Feb. 2012); ISDA (Feb. 2012); JPMC. This
issue is addressed in note 1044 and its accompanying text, infra.
    \1032\ See Goldman (Prop. Trading); RBC; SIFMA et al. (Prop.
Trading) (Feb. 2012).
    \1033\ See JPMC; Goldman (Prop. Trading).
    \1034\ See Goldman (Prop. Trading); RBC; SIFMA et al. (Prop.
Trading) (Feb. 2012). See also Morgan Stanley (requesting the
addition of the phrase ``to the extent it is legally required to be
subject to such regulation'' to the non-U.S. dealer provisions).
---------------------------------------------------------------------------

    In addition, with respect to the provisions that would generally
require a banking entity to be a form of SEC- or CFTC-registered dealer
for market-making activities in securities or derivatives in the United
States, a few commenters stated that these provisions should be removed
from the rule.\1035\ These commenters represented that removing these
provisions would be appropriate for several reasons. For example, one
commenter stated that dealer registration does not help distinguish
between market making and speculative trading.\1036\ Another commenter
indicated that effective market making often requires a banking entity
to trade on several exchange and platforms in a variety of markets,
including through legal entities other than SEC- or CFTC-registered
dealer entities.\1037\ One commenter expressed general concern that the
proposed requirement may result in the market-making exemption being
unavailable for market making in exchange-traded futures and options
because those markets do not have a corollary to dealer registration
requirements in securities, swaps, and security-based swaps
markets.\1038\
---------------------------------------------------------------------------

    \1035\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman
(Prop. Trading); Morgan Stanley; ISDA (Feb. 2012). Rather than
remove the requirement entirely, one commenter recommended that the
Agencies move the dealer registration requirement to proposed
Appendix B, which would allow the Agencies to take into account the
facts and circumstances of a particular trading activity. See JPMC.
    \1036\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1037\ See Goldman (Prop. Trading).
    \1038\ See CME Group.
---------------------------------------------------------------------------

    Some commenters expressed particular concern about the provisions
that would generally require registration as a swap dealer or a
security-based swap dealer.\1039\ For example, one commenter expressed
concern that these provisions may require banking regulators to
redundantly enforce CFTC and SEC registration requirements. Moreover,
according to this commenter, the proposed definitions of ``swap
dealer'' and ``security-based swap dealer'' do not focus on the market
making core of the swap dealing business.\1040\ Another commenter
stated that incorporating the proposed definitions of ``swap dealer''
and ``security-based swap dealer'' is contrary to the Administrative
Procedure Act.\1041\
---------------------------------------------------------------------------

    \1039\ See ISDA (Feb. 2012); SIFMA et al. (Prop. Trading) (Feb.
2012).
    \1040\ See ISDA (Feb. 2012).
    \1041\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------

c. Final Registration Requirement
    The final requirement of the market-making exemption provides that
the banking entity must be licensed or registered to engage in market
making-related activity in accordance with applicable law.\1042\ The
Agencies have considered comments regarding the dealer registration
requirement in the proposed rule.\1043\ In response to comments, the
Agencies have narrowed the scope of the proposed requirement's
application to banking entities engaged in market making-related
activity in foreign jurisdictions.\1044\ Rather than requiring these
banking entities to be subject to substantive regulation of their
dealing business in the relevant foreign jurisdiction, the final rule
only require a banking entity to be a registered dealer in a foreign
jurisdiction to the extent required by applicable foreign law. The
Agencies have also simplified the language of the proposed requirement,
although the Agencies have not modified the scope of the requirement
with respect to U.S. dealer registration requirements.
---------------------------------------------------------------------------

    \1042\ See final rule Sec.  ----.4(b)(2)(vi).
    \1043\ See supra Part IV.A.3.c.5.b. One commenter expressed
concern that the instruments listed in Sec.  ----.4(b)(2)(iv) of the
proposed rule could be interpreted as limiting the availability of
the market-making exemption to other instruments, such as exchange-
traded futures and options. In response to this comment, the
Agencies note that the reference to particular instruments in Sec.
----.4(b)(2)(iv) was intended to reflect that trading in certain
types of instruments gives rise to dealer registration requirements.
This provision was not intended to limit the availability of the
market-making exemption to certain types of financial instruments.
See CME Group.
    \1044\ See Goldman (Prop. Trading); RBC; SIFMA et al. (Prop.
Trading) (Feb. 2012); Morgan Stanley.
---------------------------------------------------------------------------

    This provision is not intended to expand the scope of licensing or
registration requirements under relevant U.S. or foreign law that are
applicable to a banking entity engaged in market-making activities.
Instead, this provision recognizes that compliance with applicable law
is an essential indicator that a banking entity is engaged in market-
making activities.\1045\ For example, a U.S. banking entity would be
expected to be an SEC-registered dealer to rely on the market-making
exemption for trading in securities--other than exempted securities,
security-based swaps, commercial paper, bankers acceptances, or
commercial bills--unless the banking entity is exempt from registration
or excluded from regulation as a dealer.\1046\ Similarly, a U.S.
banking entity is expected to be a CFTC-registered swap dealer or SEC-
registered security-based swap dealer to rely on the market-making
exemption for trading in swaps or security-based swaps,
respectively,\1047\ unless the banking entity is exempt from
registration or excluded from regulation as a swap dealer or security-
based swap dealer.\1048\ In response to comments on whether this
provision should generally require registration as a swap dealer or
security-based swap dealer to make a market in swaps or security-based
swaps,\1049\ the Agencies continue to

believe that this requirement is appropriate. In general, a person that
is engaged in making a market in swaps or security-based swaps or other
activity causing oneself to be commonly known in the trade as a market
maker in swaps or security-based swaps is required to be a registered
swap dealer or registered security-based swap dealer, unless exempt
from registration or excluded from regulation as such.\1050\ As noted
above, compliance with applicable law is an essential indicator that a
banking entity is engaged in market-making activities.
---------------------------------------------------------------------------

    \1045\ In response to commenters who stated that the dealer
registration requirement should be removed from the rule because,
among other things, registration as a dealer does not distinguish
between permitted market making and impermissible proprietary
trading, the Agencies recognize that acting as a registered dealer
does not ensure that a banking entity is engaged in permitted market
making-related activity. See SIFMA et al. (Prop. Trading) (Feb.
2012); Goldman (Prop. Trading); Morgan Stanley; ISDA (Feb. 2012).
However, this requirement recognizes that registration as a dealer
is an indicator of market making-related activities in the
circumstances in which a person is legally obligated to be a
registered dealer to act as a market maker.
    \1046\ A banking entity relying on the market-making exemption
for transactions in security-based swaps would generally be required
to be a registered security-based swap dealer and would not be
required to be a registered securities dealer. However, a banking
entity may be required to be a registered securities dealer if it
engages in market-making transactions involving security-based swaps
with persons that are not eligible contract participants. The
definition of ``dealer'' in section 3(a)(5) of the Exchange Act
generally includes ``any person engaged in the business of buying
and selling securities (not including security-based swaps, other
than security-based swaps with or for persons that are not eligible
contract participants), for such person's own account.'' 15 U.S.C.
78c(a)(5).
    To the extent, if any, that a banking entity relies on the
market-making exemption for its trading in municipal securities or
government securities, rather than the exemption in Sec.  ----.6(a)
of the final rule, this provision may require the banking entity to
be registered or licensed as a municipal securities dealer or
government securities dealer.
    \1047\ As noted above, under certain circumstances, a banking
entity acting as market maker in security-based swaps may be
required to be a registered securities dealer. See supra note 1046.
    \1048\ For example, a banking entity meeting the conditions of
the de minimis exception in SEC Rule 3a71-2 under the Exchange Act
would not need to be a registered security-based swap dealer to act
as a market maker in security-based swaps. See 17 CFR 240.3a71-2.
    \1049\ See ISDA (Feb. 2012); SIFMA et al. (Prop. Trading) (Feb.
2012).
    \1050\ See 7 U.S.C. 1a(49)(A); 15 U.S.C. 78c(a)(71)(A).
---------------------------------------------------------------------------

    As noted above, the Agencies have determined that, rather than
require a banking entity engaged in the business of a securities
dealer, swap dealer, or security-based swap dealer outside the United
States to be subject to substantive regulation of its dealing business
in the foreign jurisdiction in which the business is located, a banking
entity's dealing activity outside the U.S. should only be subject to
licensing or registration requirements under applicable foreign law
(provided no U.S. registration or licensing requirements apply to the
banking entity's activities). As a result, this requirement will not
impact a banking entity's ability to engage in permitted market making-
related activities in a foreign jurisdiction that does not provide for
substantive regulation of dealers.\1051\
---------------------------------------------------------------------------

    \1051\ See Goldman (Prop. Trading); RBC; SIFMA et al. (Prop.
Trading) (Feb. 2012); Morgan Stanley. This is consistent with one
commenter's suggestion that the Agencies add ``to the extent it is
legally required to be subject to such regulation'' to the non-U.S.
dealer provisions. See Morgan Stanley.
---------------------------------------------------------------------------

7. Source of Revenue Analysis
a. Proposed Source of Revenue Requirement
    To qualify for the market-making exemption, the proposed rule
required that the market making-related activities of the trading desk
or other organizational unit be designed to generate revenues primarily
from fees, commissions, bid/ask spreads or other income not
attributable to appreciation in the value of financial instrument
positions it holds in trading accounts or the hedging of such
positions.\1052\ This proposed requirement was intended to ensure that
activities conducted in reliance on the market-making exemption
demonstrate patterns of revenue generation and profitability consistent
with, and related to, the intermediation and liquidity services a
market maker provides to its customers, rather than changes in the
market value of the positions or risks held in inventory.\1053\
---------------------------------------------------------------------------

    \1052\ See proposed rule Sec.  ----.4(b)(2)(v).
    \1053\ See Joint Proposal, 76 FR 68,872; CFTC Proposal, 77 FR
8358.
---------------------------------------------------------------------------

b. Comments Regarding the Proposed Source of Revenue Requirement
    As discussed in more detail below, many commenters expressed
concern about the proposed source of revenue requirement. These
commenters raised a number of concerns including, among others, the
proposed requirement's potential impact on a market maker's inventory
or on costs to customers, the difficulty of differentiating revenues
from spreads and revenues from price appreciation in certain markets,
and the need for market makers to be compensated for providing
intermediation services.\1054\ Several of these commenters requested
that the proposed source of revenue requirement be removed from the
rule or modified in certain ways. Some commenters, however, expressed
support for the proposed requirement or requested that the Agencies
place greater restrictions on a banking entity's permissible sources of
revenue under the market-making exemption.\1055\
---------------------------------------------------------------------------

    \1054\ These concerns are addressed in Part IV.A.3.c.7.c.,
infra.
    \1055\ See infra note 1103 (responding to these comments).
---------------------------------------------------------------------------

i. Potential Restrictions on Inventory, Increased Costs for Customers,
and Other Changes to Market-Making Services
    Many commenters stated that the proposed source of revenue
requirement may limit a market maker's ability to hold sufficient
inventory to facilitate customer demand.\1056\ Several of these
commenters expressed particular concern about applying this requirement
to less liquid markets or to facilitating large customer positions,
where a market maker is more likely to hold inventory for a longer
period of time and has increased risk of potential price appreciation
(or depreciation).\1057\ Further, another commenter questioned how the
proposed requirement would apply when unforeseen market pressure or
disappearance of customer demand results in a market maker holding a
particular position in inventory for longer than expected.\1058\ In
response to this proposed requirement, a few commenters stated that it
is important for market makers to be able to hold a certain amount of
inventory to: Provide liquidity (particularly in the face of order
imbalances and market volatility),\1059\ facilitate large trades, and
hedge positions acquired in the course of market making.\1060\
---------------------------------------------------------------------------

    \1056\ See, e.g., NYSE Euronext; SIFMA et al. (Prop. Trading)
(Feb. 2012); Morgan Stanley; Goldman (Prop. Trading); BoA; Citigroup
(Feb. 2012); STANY; BlackRock; SIFMA (Asset Mgmt.) (Feb. 2012); ACLI
(Feb. 2012); T. Rowe Price; PUC Texas; SSgA (Feb. 2012); ICI (Feb.
2012) Invesco; MetLife; MFA.
    \1057\ See, e.g., Morgan Stanley; BoA; BlackRock; T. Rowe Price;
Goldman (Prop. Trading); NYSE Euronext (suggesting that principal
trading by market makers in large sizes is essential in some
securities, such as an AP's trading in ETFs); Prof. Duffie; SSgA
(Feb. 2012); CIEBA; SIFMA et al. (Prop. Trading) (Feb. 2012); MFA.
To explain its concern, one commenter stated that bid-ask spreads
are useful to capture the concept of market-making revenues when a
market maker is intermediating on a close to real-time basis between
balanced customer buying and selling interest for the same
instrument, but such close-in-time intermediation does not occur in
many large or illiquid assets, where demand gaps may be present for
days, weeks, or months. See Morgan Stanley.
    \1058\ See Capital Group.
    \1059\ See NYSE Euronext; CIEBA (stating that if the rule
discourages market makers from holding inventory, there will be
reduced liquidity for investors and issuers).
    \1060\ See NYSE Euronext. For a more in-depth discussion of
comments regarding the benefits of permitting market makers to hold
and manage inventory, See Part IV.A.3.c.2.b.vi., infra.
---------------------------------------------------------------------------

    Several commenters expressed concern that the proposed source of
revenue requirement may incentivize a market maker to widen its quoted
spreads or otherwise impose higher fees to the detriment of its
customers.\1061\ For example, some commenters stated that the proposed
requirement could result in a market maker having to sell a position in
its inventory within an artificially prescribed period of time and, as
a result, the market maker would pay less to initially acquire the
position from a customer.\1062\ Other commenters represented that the
proposed source of revenue requirement would compel market makers to
hedge their exposure to price movements, which would likely increase
the cost of intermediation.\1063\
---------------------------------------------------------------------------

    \1061\ See, e.g., Wellington; CIEBA; MetLife; ACLI (Feb. 2012);
SSgA (Feb. 2012); PUC Texas; ICI (Feb. 2012) BoA.
    \1062\ See MetLife; ACLI (Feb. 2012); ICI (Feb. 2012) SSgA (Feb.
2012).
    \1063\ See SSgA (Feb. 2012); PUC Texas.
---------------------------------------------------------------------------

    Some commenters stated that the proposed source of revenue
requirement may make a banking entity less willing to make markets in
instruments that it may not be able to resell immediately or in the
short term.\1064\ One commenter indicated that this concern may be
heightened in times of market stress.\1065\ Further, a few commenters
expressed the view that the proposed requirement would cause banking
entities to exit the

market-making business due to restrictions on their ability to make a
profit from market-making activities.\1066\ Moreover, in one
commenter's opinion, the proposed requirement would effectively compel
market makers to trade on an agency basis.\1067\
---------------------------------------------------------------------------

    \1064\ See ICI (Feb. 2012) SSgA (Feb. 2012); SIFMA (Asset Mgmt.)
(Feb. 2012); BoA.
    \1065\ See CIEBA (arguing that banking entities may be reluctant
to provide liquidity when markets are declining and there are more
sellers than buyers because it would be necessary to hold positions
in inventory to avoid losses).
    \1066\ See Credit Suisse (Seidel) (arguing that banking entities
are likely to cease being market makers if they are: (i) Unable to
take into account the likely direction of a financial instrument, or
(ii) forced to take losses if a financial instrument moves against
them, but cannot take gains if the instrument's price moves in their
favor); STANY (contending that banking entities cannot afford to
maintain unprofitable or marginally profitable operations in highly
competitive markets, so this requirement would cause banking
entities to eliminate a majority of their market-making functions).
    \1067\ See IR&M (arguing that domestic corporate and securitized
credit markets are too large and heterogeneous to be served
appropriately by a primarily agency-based trading model).
---------------------------------------------------------------------------

ii. Certain Price Appreciation-Related Profits Are an Inevitable or
Important Component of Market Making
    A number of commenters indicated that market makers will inevitably
make some profit from price appreciation of certain inventory positions
because changes in market values cannot be precisely predicted or
hedged.\1068\ In particular, several commenters emphasized that matched
or perfect hedges are generally unavailable for most types of
positions.\1069\ According to one commenter, a provision that
effectively requires a market-making business to hedge all of its
principal positions would discourage essential market-making activity.
The commenter explained that effective hedges may be unavailable in
less liquid markets and hedging can be costly, especially in relation
to the relative risk of a trade and hedge effectiveness.\1070\ A few
commenters further indicated that making some profit from price
appreciation is a natural part of market making or is necessary to
compensate a market maker for its willingness to take a position, and
its associated risk (e.g., the risk of market changes or decreased
value), from a customer.\1071\
---------------------------------------------------------------------------

    \1068\ See Wellington; Credit Suisse (Seidel); Morgan Stanley;
PUC Texas (contending that it is impossible to predict the behavior
of even the most highly correlated hedge in comparison to the
underlying position); CIEBA; SSgA (Feb. 2012); AllianceBernstein;
Investure; Invesco.
    \1069\ See Morgan Stanley; Credit Suisse (Seidel); SSgA (Feb.
2012); PUC Texas; Wellington; AllianceBernstein; Investure.
    \1070\ See Wellington. Moreover, one commenter stated that, as a
general matter, market makers need to be compensated for bearing
risk related to providing immediacy to a customer. This commenter
stated that ``[t]he greater the inventory risk faced by the market
maker, the higher the expected return (compensation) that the market
maker needs,'' to compensate the market maker for bearing the risk
and reward its specialization skills in that market (e.g., its
knowledge about market conditions and early indicators that may
imply future price movements in a particular direction). This
commenter did not, however, discuss the source of revenue
requirement in the proposed rule. See Thakor Study.
    \1071\ See Capital Group; Prof. Duffie; Investure; SIFMA et al.
(Prop. Trading) (Feb. 2012); STANY; SIFMA (Asset Mgmt.) (Feb. 2012);
RBC; PNC.
---------------------------------------------------------------------------

iii. Concerns Regarding the Workability of the Proposed Standard in
Certain Markets or Asset Classes
    Some commenters represented that it would be difficult or
burdensome to identify revenue attributable to the bid-ask spread
versus revenue arising from price appreciation, either as a general
matter or for specific markets.\1072\ For example, one commenter
expressed the opinion that the difference between the bid-ask spread
and price appreciation is ``metaphysical'' in some sense,\1073\ while
another stated that it is almost impossible to objectively identify a
bid-ask spread or to capture profit and loss solely from a bid-ask
spread in most markets.\1074\ Other commenters represented that it is
particularly difficult to make this distinction when trades occur
infrequently or where prices are not transparent, such as in the fixed-
income market where no spread is published.\1075\
---------------------------------------------------------------------------

    \1072\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);
Goldman (Prop. Trading); BoA; Citigroup (Feb. 2012); Japanese
Bankers Ass'n.; Sumitomo Trust; Morgan Stanley; Barclays; RBC;
Capital Group.
    \1073\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1074\ See Citigroup (Feb. 2012). See also Barclays (arguing
that a bid-ask spread cannot be defined on a consistent basis with
respect to many instruments).
    \1075\ See Goldman (Prop. Trading); BoA; Morgan Stanley
(``Observable, actionable, bid/ask spreads exist in only a small
subset of institutional products and markets. Indicative bid/ask
spreads may be observable for certain products, but this pricing
would typically be specific to small size standard lot trades and
would not represent a spread applicable to larger and/or more
illiquid trades. End-of-day valuations for assets are calculated,
but they are not an effective proxy for real-time bid/ask spreads
because of intra-day price movements.''); RBC; Capital Group
(arguing that bid-ask spreads in fixed-income markets are not always
quantifiable or well defined and can fluctuate widely within a
trading day because of small or odd lot trades, price discovery
activity, a lack of availability to cover shorts, or external
factors not directly related to the security being traded).
---------------------------------------------------------------------------

    Many commenters expressed particular concern about the proposed
requirement's application to specific markets, including: The fixed-
income markets; \1076\ the markets for commodities, derivatives,
securitized products, and emerging market securities; \1077\ equity and
physical commodity derivatives markets; \1078\ and customized swaps
used by customers of banking entities for hedging purposes.\1079\
Another commenter expressed general concern about extremely volatile
markets, where market makers often see large upward or downward price
swings over time.\1080\
---------------------------------------------------------------------------

    \1076\ See Capital Group; CIEBA; SIFMA et al. (Prop. Trading)
(Feb. 2012); SSgA (Feb. 2012). These commenters stated that the
requirement may be problematic for the fixed-income markets because,
for example, market makers must hold inventory in these markets for
a longer period of time than in more liquid markets. See id.
    \1077\ See SIFMA et al. (Prop. Trading) (Feb. 2012) (stating
that these markets are characterized by even less liquidity and less
frequent trading than the U.S. corporate bond market). This
commenter also stated that in markets where trades are large and
less frequent, such as the market for customized securitized
products, appreciation in price of one position may be a predominate
contributor to the overall profit and loss of the trading unit. See
id.
    \1078\ See BoA. According to this commenter, the distinction
between capturing a spread and price appreciation is fundamentally
flawed in some markets, like equity derivatives, because the market
does not trade based on movements of a particular security or
underlying instrument. This commenter indicated that expected
returns are instead based on the bid-ask spread the market maker
charges for implied volatility as reflected in options premiums and
hedging of the positions. See id.
    \1079\ See CIEBA (stating that because it would be difficult for
a market maker to enter promptly into an offsetting swap, the market
maker would not be able to generate income from the spread).
    \1080\ See SIFMA et al. (Prop. Trading) (Feb. 2012). This
commenter questioned whether proposed Appendix B's reference to
``unexpected market disruptions'' as an explanatory fact and
circumstance was intended to permit such market making. See id.
---------------------------------------------------------------------------

    Two commenters emphasized that the revenues a market maker
generates from hedging the positions it holds in inventory are
equivalent to spreads in many markets. These commenters explained that,
under these circumstances, a market maker generates revenue from the
difference between the customer price for the position and the banking
entity's price for the hedge. The commenters noted that proposed
Appendix B expressly recognizes this in the case of derivatives and
recommended that Appendix B's guidance on this point apply equally to
certain non-derivative positions.\1081\
---------------------------------------------------------------------------

    \1081\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman
(Prop. Trading). In its discussion of ``customer revenues,''
Appendix B states: ``In the case of a derivative contract, these
revenues reflect the difference between the cost of entering into
the derivative contract and the cost of hedging incremental,
residual risks arising from the contract.'' Joint Proposal, 76 FR
68,960; CFTC Proposal, 77 FR 8440. See also RBC (requesting
clarification on how the proposed standard would apply if a market
maker took an offsetting position in a different instrument (e.g., a
different bond) and inquiring whether, if the trader took the
offsetting position, its revenue gain is attributable to price
appreciation of the two offsetting positions or from the bid-ask
spread in the respective bonds).
---------------------------------------------------------------------------

    A few commenters questioned how this requirement would work in the
context of block trading or otherwise facilitating large trades, where
a market maker may charge a premium or discount for taking on a large
position

to provide ``immediacy'' to its customer.\1082\ One commenter further
explained that explicitly quoted bid-ask spreads are only valid for
indicated trade sizes that are modest enough to have negligible market
impact, and such spreads cannot be used for purposes of a significantly
larger trade.\1083\
---------------------------------------------------------------------------

    \1082\ See Prof. Duffie; NYSE Euronext; Capital Group; RBC;
Goldman (Prop. Trading). See also Thakor Study (discussing market
makers' role of providing ``immediacy'' in general).
    \1083\ See CIEBA.
---------------------------------------------------------------------------

iv. Suggested Modifications to the Proposed Requirement
    To address some or all of the concerns discussed above, many
commenters recommended that the source of revenue requirement be
modified \1084\ or removed from the rule entirely.\1085\ With respect
to suggested changes, some commenters stated that the Agencies should
modify the rule text,\1086\ use a metrics-based approach to focus on
customer revenues,\1087\ or replace the proposed requirement with
guidance.\1088\ Some commenters requested that the Agencies modify the
focus of the requirement so that, for example, dealers' market-making
activities in illiquid securities can function as close to normal as
possible \1089\ or market makers can take short-term positions that may
ultimately result in a profit or loss.\1090\ As discussed below, some
commenters stated that the Agencies should modify the proposed
requirement to place greater restrictions on market maker revenue.
---------------------------------------------------------------------------

    \1084\ See, e.g., JPMC; Barclays; Goldman (Prop. Trading); BoA;
CFA Inst.; ICI (Feb. 2012) Flynn & Fusselman.
    \1085\ See, e.g., CIEBA; SIFMA et al. (Prop. Trading) (Feb.
2012); Morgan Stanley; Goldman (Prop. Trading); Capital Group; RBC.
In addition to the concerns discussed above, one commenter stated
that the proposed requirement may set limits on the values of
certain metrics, and it would be inappropriate to prejudge the
appropriate results of such metrics at this time. See SIFMA et al.
(Prop. Trading) (Feb. 2012).
    \1086\ See, e.g., Barclays. This commenter provided alternative
rule text stating that ``market making-related activity is conducted
by each trading unit such that its activities are reasonably
designed to generate revenues primarily from fees, commissions, bid-
ask spreads, or other income attributable to satisfying reasonably
expected customer demand.'' See id.
    \1087\ See Goldman (Prop. Trading) (suggesting that the Agencies
use a metrics-based approach to focus on customer revenues, as
measured by Spread Profit and Loss (when it is feasible to
calculate) or other metrics, especially because a proprietary
trading desk would not be expected to earn any revenues this way).
This commenter also indicated that the ``primarily'' standard in the
proposed rule is problematic and can be read to mean ``more than
50%,'' which is different from Appendix B's acknowledgment that the
proportion of customer revenues relative to total revenues will vary
by asset class. See id.
    \1088\ See BoA (recommending that the guidance state that the
Agencies would consider the design and mix of such revenues as an
indicator of potentially prohibited proprietary trading, but only
for those markets for which revenues are quantifiable based on
publicly available data, such as segments of certain highly liquid
equity markets).
    \1089\ See CFA Inst.
    \1090\ See ICI (Feb. 2012).
---------------------------------------------------------------------------

v. General Support for the Proposed Requirement or for Placing Greater
Restrictions on a Market Maker's Sources of Revenue
    Some commenters expressed support for the proposed source of
revenue requirement or stated that the requirement should be more
restrictive.\1091\ For example, one of these commenters stated that a
real market maker's trading book should be fully hedged, so it should
not generate profits in excess of fees and commissions except in times
of rare and extraordinary market conditions.\1092\ According to another
commenter, the final rule should make it clear that banking entities
seeking to rely on the market-making exemption may not generally seek
to profit from price movements in their inventories, although their
activities may give rise to modest and relatively stable profits
arising from their limited inventory.\1093\ One commenter recommended
that the proposed requirement be interpreted to limit market making in
illiquid positions because a banking entity cannot have the required
revenue motivation when it enters into a position for which there is no
readily discernible exit price.\1094\
---------------------------------------------------------------------------

    \1091\ See Sens. Merkley & Levin (Feb. 2012); Better Markets
(Feb. 2012); FTN; Public Citizen; Occupy; Alfred Brock.
    \1092\ See Better Markets (Feb. 2012). See also Public Citizen
(arguing that the imperfection of a hedge should signal potential
disqualification of the underlying position from the market-making
exemption).
    \1093\ See Sens. Merkley & Levin (Feb. 2012). This commenter
further suggested that the rule identify certain red flags and
metrics that could be used to monitor this requirement, such as: (i)
Failure to obtain relatively low ratios of revenue-to-risk, low
volatility, and relatively high turnover; (ii) significant revenues
from price appreciation relative to the value of securities being
traded; (iii) volatile revenues from price appreciation; or (iv)
revenue from price appreciation growing out of proportion to the
risk undertaken with the security. See id.
    \1094\ See AFR et al. (Feb. 2012).
---------------------------------------------------------------------------

    Further, some commenters suggested that the Agencies remove the
word ``primarily'' from the provision to limit banking entities to
specified sources of revenue.\1095\ In addition, one of these
commenters requested that the Agencies restrict a market maker's
revenue to fees and commissions and remove the allowance for revenue
from bid-ask spreads because generating bid-ask revenues relies
exclusively on changes in market values of positions held in
inventory.\1096\ For enforcement purposes, a few commenters suggested
that the Agencies require banking entities to disgorge any profit
obtained from price appreciation.\1097\
---------------------------------------------------------------------------

    \1095\ See Occupy; Better Markets (Feb. 2012). See supra note
1103 (addressing these comments).
    \1096\ See Occupy.
    \1097\ See Occupy; Public Citizen.
---------------------------------------------------------------------------

c. Final Rule's Approach to Assessing Revenues
    Unlike the proposed rule, the final rule does not include a
requirement that a trading desk's market making-related activity be
designed to generate revenue primarily from fees, commissions, bid-ask
spreads, or other income not attributable to appreciation in the value
of a financial instrument or hedging.\1098\ The revenue requirement was
one of the most commented upon aspects of the market-making exemption
in the proposal.\1099\
---------------------------------------------------------------------------

    \1098\ See proposed rule Sec.  ----.4(b)(2)(v).
    \1099\ See infra Part IV.A.3.c.7.b.
---------------------------------------------------------------------------

    The Agencies believe that an analysis of patterns of revenue
generation and profitability can help inform a judgment regarding
whether trading activity is consistent with the intermediation and
liquidity services that a market maker provides to its customers in the
context of the liquidity, maturity, and depth of the relevant market,
as opposed to prohibited proprietary trading activities. To facilitate
this type of analysis, the Agencies have included a metrics data
reporting requirement that is refined from the proposed metric
regarding profits and losses. The Comprehensive Profit and Loss
Attribution metric collects information regarding the daily fluctuation
in the value of a trading desk's positions to various sources, along
with its volatility, including: (i) Profit and loss attributable to
current positions that were also held by the banking entity as of the
end of the prior day (``existing positions); (ii) profit and loss
attributable to new positions resulting from the current day's trading
activity (``new positions''); and (iii) residual profit and loss that
cannot be specifically attributed to existing positions or new
positions.\1100\
---------------------------------------------------------------------------

    \1100\ See Appendix A of the final rule (describing the
Comprehensive Profit and Loss Attribution metric). This approach is
generally consistent with one commenter's suggested metrics-based
approach to focus on customer-related revenues. See Goldman (Prop.
Trading); See also Sens. Merkley & Levin (Feb. 2012) (suggesting the
use of metrics to monitor a firm's source of revenue); proposed
Appendix A.
---------------------------------------------------------------------------

    This quantitative measurement has certain conceptual similarities
to the proposed source of revenue requirement in Sec.  ----.4(b)(2)(v)
of the proposed rule

and certain of the proposed quantitative measurements.\1101\ However,
in response to comments on those provisions, the Agencies have
determined to modify the focus from particular revenue sources (e.g.,
fees, commissions, bid-ask spreads, and price appreciation) to when the
trading desk generates revenue from its positions. The Agencies
recognize that when the trading desk is engaged in market making-
related activities, the day one profit and loss component of the
Comprehensive Profit and Loss Attribution metric may reflect customer-
generated revenues, like fees, commissions, and spreads (including
embedded premiums or discounts), as well as that day's changes in
market value. Thereafter, profit and loss associated with the position
carried in the trading desk's book may reflect changes in market price
until the position is sold or unwound. The Agencies also recognize that
the metric contains a residual component for profit and loss that
cannot be specifically attributed to existing positions or new
positions.
---------------------------------------------------------------------------

    \1101\ See supra Part IV.A.3.c.7. and infra Part IV.C.3.
---------------------------------------------------------------------------

    The Agencies believe that evaluation of the Comprehensive Profit
and Loss Attribution metric could provide valuable information
regarding patterns of revenue generation by market-making trading desks
involved in market-making activities that may warrant further review of
the desk's activities, while eliminating the requirement from the
proposal that the trading desk demonstrate that its primary source of
revenue, under all circumstances, is fees, commissions and bid/ask
spreads. This modified focus will reduce the burden associated with the
proposed source of revenue requirement and better account for the
varying depth and liquidity of markets.\1102\ In addition, the Agencies
believe these modifications appropriately address commenters' concerns
about the proposed source of revenue requirement and reduce the
potential for negative market impacts of the proposed requirement cited
by commenters, such as incentives to widen spreads or disincentives to
engage in market making in less liquid markets.\1103\
---------------------------------------------------------------------------

    \1102\ The Agencies understand that some commenters interpreted
the proposed requirement as requiring that both the bid-ask spread
for a financial instrument and the revenue a market maker acquired
from such bid-ask spread through a customer trade be identifiable on
a close-to-real-time basis and readily distinguishable from any
additional revenue gained from price appreciation (both on the day
of the transaction and for the rest of the holding period). See,
e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop.
Trading); BoA; Citigroup (Feb. 2012); Japanese Bankers Ass'n.;
Sumitomo Trust; Morgan Stanley; Barclays; RBC; Capital Group. We
recognize that such a requirement would be unduly burdensome. In
fact, the proposal noted that bid-ask spreads or similar spreads may
not be widely disseminated on a consistent basis or otherwise
reasonably ascertainable in certain asset classes for purposes of
the proposed Spread Profit and Loss metric in Appendix A of the
proposal. See Joint Proposal, 76 FR 68,958-68,959; CFTC Proposal, 77
FR 8438. Moreover, the burden associated with the proposed
requirement should be further reduced because we are not adopting a
stand-alone requirement regarding a trading desk's source of
revenue. Instead, when and how a trading desk generates profit and
loss from its trading activities is a factor that must be considered
for purposes of the near term customer demand requirement. It is not
a dispositive factor for determining compliance with the exemption.
    Further, some commenters expressed concern that the proposed
requirement suggested market makers were not permitted to profit
from price appreciation, but rather only from observable spreads or
explicit fees or commissions. See, e.g., Wellington, Credit Suisse
(Seidel); Morgan Stanley; PUC Texas; CIEBA; SSgA (Feb. 2012);
AllianceBernstein; Investure; Invesco. The Agencies confirm that the
intent of the market-making exemption is not to preclude a trading
desk from generating any revenue from price appreciation. Because
this approach clarifies that a trading desk's source of revenue is
not limited to its quoted spread, the Agencies believe this
quantitative measurement will address commenters concerns that the
proposed source of revenue requirement could create incentives for
market makers to widen their spreads, result in higher transaction
costs, require market makers to hedge any exposure to price
movements, or discourage a trading desk from making a market in
instruments that it may not be able to sell immediately. See
Wellington; CIEBA; MetLife; ACLI (Feb. 2012); SSgA (Feb. 2012); PUC
Texas; ICI (Feb. 2012) BoA; SIFMA (Asset Mgmt.) (Feb. 2012). The
modifications to this provision are designed to better reflect when,
on average and across many transactions, profits are gained rather
than how they are gained, similar to the way some firms measure
their profit and loss today. See, e.g., Goldman (Prop. Trading).
    \1103\ See, e.g., Wellington; CIEBA; MetLife; ACLI (Feb. 2012);
SSgA (Feb. 2012); PUC Texas; ICI (Feb. 2012) BoA. The Agencies are
not adopting an approach that limits a market maker to specified
revenue sources (e.g., fees, commissions, and spreads), as suggested
by some commenters, due to the considerations discussed above. See
Occupy; Better Markets (Feb. 2012). In response to the proposed
source of revenue requirement, some commenters noted that a market
maker may charge a premium or discount for taking on a large
position from a customer. See Prof. Duffie; NYSE Euronext; Capital
Group; RBC; Goldman (Prop. Trading).
---------------------------------------------------------------------------

    The Agencies recognize that this analysis is only informative over
time, and should not be determinative of an analysis of whether the
amount, types, and risks of the financial instruments in the trading
desk's market-maker inventory are designed not to exceed the reasonably
expected near term demands of clients, customers, or counterparties.
The Agencies believe this quantitative measurement provides appropriate
flexibility to obtain information on market-maker revenues, which is
designed to address commenters' concerns about the proposal's source of
revenue requirement (e.g., the burdens associated with differentiating
spread revenue from price appreciation revenue) while also helping
assess patterns of revenue generation that may be informative over time
about whether a market maker's activities are designed to facilitate
and provide customer intermediation.
8. Appendix B of the Proposed Rule
a. Proposed Appendix B Requirement
    The proposed market-making exemption would have required that the
market making-related activities of the trading desk or other
organizational unit of the banking entity be consistent with the
commentary in proposed Appendix B.\1104\ In this proposed Appendix, the
Agencies provided overviews of permitted market making-related activity
and prohibited proprietary trading activity.\1105\
---------------------------------------------------------------------------

    \1104\ See proposed rule Sec.  ----.4(b)(2)(vi).
    \1105\ See Joint Proposal, 76 FR 68,873, 68,960-68,961; CFTC
Proposal, 77 FR 8358, 8439-8440.
---------------------------------------------------------------------------

    The proposed Appendix also set forth various factors that the
Agencies proposed to use to help distinguish prohibited proprietary
trading from permitted market making-related activity. More
specifically, proposed Appendix B set forth six factors that, absent
explanatory facts and circumstances, would cause particular trading
activity to be considered prohibited proprietary trading activity and
not permitted market making-related activity. The proposed factors
focused on: (i) Retaining risk in excess of the size and type required
to provide intermediation services to customers (``risk management
factor''); (ii) primarily generating revenues from price movements of
retained principal positions and risks, rather than customer revenues
(``source of revenues factor''); (iii) generating only very small or
very large amounts of revenue per unit of risk, not demonstrating
consistent profitability, or demonstrating high earnings volatility
(``revenues relative to risk factor''); (iv) not trading through a
trading system that interacts with orders of others or primarily with
customers of the banking entity's market-making desk to provide
liquidity services, or retaining principal positions in excess of
reasonably expected near term customer demands (``customer-facing
activity factor''); (v) routinely paying rather than earning fees,
commissions, or spreads (``payment of fees, commissions, and spreads
factor''); and (vi) providing compensation incentives to employees that
primarily reward proprietary risk-

taking (``compensation incentives factor'').\1106\
---------------------------------------------------------------------------

    \1106\ See Joint Proposal, 76 FR 68,873, 68,961-68,963; CFTC
Proposal, 77 FR 8358, 8440-8442.
---------------------------------------------------------------------------

b. Comments on Proposed Appendix B
    Commenters expressed differing views about the accuracy of the
commentary in proposed Appendix B and the appropriateness of including
such commentary in the rule. For example, some commenters stated that
the description of market making-related activity in the proposed
appendix is accurate \1107\ or appropriately accounts for differences
among asset classes.\1108\ Other commenters indicated that the appendix
is too strict or narrow.\1109\ Some commenters recommended that the
Agencies revise proposed Appendix B's approach by, for example, placing
greater focus on what market making is rather than what it is
not,\1110\ providing presumptions of activity that will be treated as
permitted market making-related activity,\1111\ re-formulating the
appendix as nonbinding guidance,\1112\ or moving certain requirements
of the proposed exemption to the appendix.\1113\ One commenter
suggested the Agencies remove Appendix B from the rule and instead use
the conformance period to analyze and develop a body of supervisory
guidance that appropriately characterizes the nature of market making-
related activity.\1114\
---------------------------------------------------------------------------

    \1107\ See MetLife; ACLI (Feb. 2012).
    \1108\ See Alfred Brock. But See, e.g., Occupy (stating that the
proposed commentary only accounts for the most liquid and
transparent markets and fails to accurately describe market making
in most illiquid or OTC markets).
    \1109\ See Morgan Stanley; IIF; Sumitomo Trust; ISDA (Apr.
2012); BDA (Feb. 2012) (Oct. 2012) (stating that proposed Appendix B
places too great of a focus on derivatives trading and does not
reflect how principal trading operations in equity and fixed income
markets are structured). One of these commenters requested that the
appendix be modified to account for certain activities conducted in
connection with market making in swaps. This commenter indicated
that a swap dealer may not regularly enjoy a dominant flow of
customer revenues and may consistently need to make revenue from its
book management. In addition, the commenter stated that the appendix
should recognize that making a two-way market may be a dominant
theme, but there are certain to be frequent occasions when, as a
matter of market or internal circumstances, a market maker is
unavailable to trade. See ISDA (Apr. 2012).
    \1110\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1111\ See Sens. Merkley & Levin (Feb. 2012). This commenter
stated that, for example, Appendix B could deem market making
involving widely-traded stocks and bonds issued by well-established
corporations, government securities, or highly liquid asset-backed
securities as the type of plain vanilla, low risk capital activities
that are presumptively permitted, provided the activity is within
certain, specified parameters for inventory levels, revenue-to-risk
metrics, volatility, and hedging. See id.
    \1112\ See Morgan Stanley; Flynn & Fusselman.
    \1113\ See JPMC. In support of such an approach, the commenter
argued that sometimes proposed Sec.  ----.4(b) and Appendix B
addressed the same topic and, when this occurs, it is unclear
whether compliance with Appendix B constitutes compliance with Sec.
----.4(b) or if additional compliance steps are required. See id.
    \1114\ See Morgan Stanley.
---------------------------------------------------------------------------

    A few commenters expressed concern about the appendix's facts-and-
circumstances-based approach to distinguishing between prohibited
proprietary trading and permitted market making-related activity and
stated that such an approach will make it more difficult or burdensome
for banking entities to comply with the proposed rule \1115\ or will
generate regulatory uncertainty.\1116\ As discussed below, other
commenters opposed proposed Appendix B because of its level of
granularity \1117\ or due to perceived restrictions on interdealer
trading or generating revenue from retained principal positions or
risks in the proposed appendix.\1118\ A number of commenters expressed
concern about the complexity or prescriptiveness of the six proposed
factors for distinguishing permitted market making-related activity
from prohibited proprietary trading.\1119\
---------------------------------------------------------------------------

    \1115\ See NYSE Euronext; Morgan Stanley.
    \1116\ See IAA.
    \1117\ See Wellington; Goldman (Prop. Trading); SIFMA (Asset
Mgmt.) (Feb. 2012).
    \1118\ See Morgan Stanley; Chamber (Feb. 2012); Goldman (Prop.
Trading).
    \1119\ See Japanese Bankers Ass'n.; Credit Suisse (Seidel);
Chamber (Feb. 2012); ICFR; Morgan Stanley; Goldman (Prop. Trading);
Occupy; Oliver Wyman (Feb. 2012); Oliver Wyman (Dec. 2011); Public
Citizen; NYSE Euronext. But See Alfred Brock (stating that the
proposed factors are effective).
---------------------------------------------------------------------------

    With respect to the level of granularity of proposed Appendix B, a
number of commenters expressed concern that the reference to a ``single
significant transaction'' indicated that the Agencies will review
compliance with the proposed market-making exemption on a trade-by-
trade basis and stated that assessing compliance at the level of
individual transactions would be unworkable.\1120\ One of these
commenters further stated that assessing compliance at this level of
granularity would reduce a market maker's willingness to execute a
customer sell order as principal due to concern that the market maker
may not be able to immediately resell such position. The commenter
noted that this chilling effect would be heightened in declining
markets.\1121\
---------------------------------------------------------------------------

    \1120\ See Wellington; Goldman (Prop. Trading); SIFMA (Asset
Mgmt.) (Feb. 2012). In particular, proposed Appendix B provided that
``The particular types of trading activity described in this
appendix may involve the aggregate trading activities of a single
trading unit, a significant number or series of transactions
occurring at one or more trading units, or a single significant
transaction, among other potential scenarios.'' Joint Proposal, 76
FR 68,961; CFTC Proposal, 77 FR 8441. The Agencies address
commenters' trade-by-trade concerns in Part IV.A.3.c.1.c.ii., infra.
    \1121\ See Goldman (Prop. Trading).
---------------------------------------------------------------------------

    A few commenters interpreted certain statements in proposed
Appendix B as limiting interdealer trading and expressed concerns
regarding potential limitations on this activity.\1122\ These
commenters emphasized that market makers may need to trade with non-
customers to: (i) Provide liquidity to other dealers and, indirectly,
their customers, or to otherwise allow customers to access a larger
pool of liquidity; \1123\ (ii) conduct price discovery to inform the
prices a market maker can offer to customers; \1124\ (iii) unwind or
sell positions acquired from customers; \1125\ (iv) establish or
acquire positions to meet reasonably expected near term customer
demand; \1126\ (v) hedge; \1127\ and (vi) sell a financial instrument
when there are more buyers than sellers for the instrument at that
time.\1128\ Further, one of these commenters expressed the view that
the proposed appendix's statements are inconsistent with the statutory
market-making exemption's reference to ``counterparties.'' \1129\
---------------------------------------------------------------------------

    \1122\ See Morgan Stanley; Goldman (Prop. Trading); Chamber
(Feb. 2012). Specifically, commenters cited statements in proposed
Appendix B indicating that market makers ``typically only engage in
transactions with non-customers to the extent that these
transactions directly facilitate or support customer transactions.''
On this issue, the appendix further stated that ``a market maker
generally only transacts with non-customers to the extent necessary
to hedge or otherwise manage the risks of its market making-related
activities, including managing its risk with respect to movements of
the price of retained principal positions and risks, to acquire
positions in amounts consistent with reasonably expected near term
demand of its customers, or to sell positions acquired from its
customers.'' The appendix recognized, however, that the
``appropriate proportion of a market maker's transactions that are
with customers versus non-customers varies depending on the type of
positions involved and the extent to which the positions are
typically hedged in non-customer transactions.'' Joint Proposal, 76
FR 68,961; CFTC Proposal, 77 FR 8440. Commenters' concerns regarding
interdealer trading are addressed in Part IV.A.3.c.2.c.i., infra.
    \1123\ See Morgan Stanley; Goldman (Prop. Trading).
    \1124\ See Morgan Stanley; Goldman (Prop. Trading); Chamber
(Feb. 2012).
    \1125\ See Morgan Stanley; Chamber (Feb. 2012) (stating that
market makers in the corporate bond, interest rate derivative, and
natural gas derivative markets frequently trade with other dealers
to work down a concentrated position originating with a customer
trade).
    \1126\ See Morgan Stanley; Chamber (Feb. 2012).
    \1127\ See Goldman (Prop. Trading).
    \1128\ See Chamber (Feb. 2012).
    \1129\ See Goldman (Prop. Trading).

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

    In addition, a few commenters expressed concern about statements in
proposed Appendix B about a market maker's source of revenue.\1130\
According to one commenter, the statement that profit and loss
generated by inventory appreciation or depreciation must be
``incidental'' to customer revenues is inconsistent with market making-
related activity in less liquid assets and larger transactions because
market makers often must retain principal positions for longer periods
of time in such circumstances and are unable to perfectly hedge these
positions.\1131\ As discussed above with respect to the source of
revenue requirement in Sec.  ----.4(b)(v) of the proposed rule, a few
commenters requested that Appendix B's discussion of ``customer
revenues'' be modified to state that revenues from hedging will be
considered to be customer revenues in certain contexts beyond
derivatives contracts.\1132\
---------------------------------------------------------------------------

    \1130\ See Morgan Stanley; SIFMA et al. (Prop. Trading) (Feb.
2012); Goldman (Prop. Trading). On this issue, Appendix B stated
that certain types of ``customer revenues'' provide the primary
source of a market maker's profitability and, while a market maker
also incurs losses or generates profits as price movements occur in
its retained principal positions and risks, ``such losses or profits
are incidental to customer revenues and significantly limited by the
banking entity's hedging activities.'' Joint Proposal, 76 FR 68,960;
CFTC Proposal, 77 FR 8440. The Agencies address commenters' concerns
about proposed requirements regarding a market maker's source of
revenue in Part IV.A.3.c.7.c., infra.
    \1131\ See Morgan Stanley.
    \1132\ See supra note 1081 and accompanying text.
---------------------------------------------------------------------------

    A number of commenters discussed the six proposed factors in
Appendix B that, absent explanatory facts and circumstances, would have
caused a particular trading activity to be considered prohibited
proprietary trading activity and not permitted market making-related
activity.\1133\ With respect to the proposed factors, one commenter
indicated that they are appropriate,\1134\ while another commenter
stated that they are complex and their effectiveness is
uncertain.\1135\ Another commenter expressed the view that ``[w]hile
each of the selected factors provides evidence of `proprietary
trading,' warrants regulatory attention, and justifies a shift in the
burden of proof, some require subjective judgments, are subject to
gaming or data manipulation, and invite excessive reliance on
circumstantial evidence and lawyers' opinions.'' \1136\
---------------------------------------------------------------------------

    \1133\ See supra note 1106 and accompanying text.
    \1134\ See Alfred Brock.
    \1135\ See Japanese Bankers Ass'n.
    \1136\ Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

    In response to the proposed risk management factor,\1137\ one
commenter expressed concern that it could prevent a market maker from
warehousing positions in anticipation of predictable but unrealized
customer demands and, further, could penalize a market maker that
misestimated expected demand. This commenter expressed the view that
such an outcome would be contrary to the statute and would harm market
liquidity.\1138\ Another commenter requested that this presumption be
removed because in less liquid markets, such as markets for corporate
bonds, equity derivatives, securitized products, emerging markets,
foreign exchange forwards, and fund-linked products, a market maker
needs to act as principal to facilitate client requests and, as a
result, will be exposed to risk.\1139\
---------------------------------------------------------------------------

    \1137\ The proposed appendix stated that the Agencies would use
certain quantitative measurements required in proposed Appendix A to
help assess the extent to which a trading unit's risks are
potentially being retained in excess amounts, including VaR, Stress
VaR, VaR Exceedance, and Risk Factor Sensitivities. See Joint
Proposal, 76 FR 68,961-68,962; CFTC Proposal, 77 FR 8441. One
commenter questioned whether, assuming such metrics are effective
and the activity does not exceed the banking entity's expressed risk
appetite, it is necessary to place greater restrictions on risk-
taking, based on the Agencies' judgment of the level of risk
necessary for bona fide market making. See ICFR.
    \1138\ See Chamber (Feb. 2012).
    \1139\ See Credit Suisse (Seidel).
---------------------------------------------------------------------------

    Two commenters expressed concern about the proposed source of
revenue factor.\1140\ One commenter stated that this factor does not
accurately reflect how market making occurs in a majority of markets
and asset classes.\1141\ The other commenter expressed concern that
this factor shifted the emphasis of Sec.  ----.4(b)(v) of the proposed
rule, which required that market making-related activities be
``designed'' to generate revenue primarily from certain sources, to the
actual outcome of activities.\1142\
---------------------------------------------------------------------------

    \1140\ See Goldman (Prop. Trading); Morgan Stanley.
    \1141\ See Morgan Stanley.
    \1142\ See Goldman (Prop. Trading). This commenter suggested
that the Agencies remove any negative presumptions based on revenues
and instead use revenue metrics, such as Spread Profit and Loss
(when it is feasible to calculate) or other metrics for purposes of
monitoring a banking entity's trading activity. See id.
---------------------------------------------------------------------------

    With respect to the proposed revenues relative to risk factor, one
commenter supported this aspect of the proposal.\1143\ Some commenters,
however, expressed concern about using these factors to differentiate
permitted market making-related activity from prohibited proprietary
trading.\1144\ These commenters stated that volatile risk-taking and
revenue can be a natural result of principal market-making
activity.\1145\ One commenter noted that customer flows are often
``lumpy'' due to, for example, a market maker's facilitation of large
trades.\1146\
---------------------------------------------------------------------------

    \1143\ See Occupy (stating that these factors are important and
will provide invaluable information about the nature of the banking
entity's trading activity).
    \1144\ See Morgan Stanley; Credit Suisse (Seidel); Oliver Wyman
(Feb. 2012); Oliver Wyman (Dec. 2011).
    \1145\ See Morgan Stanley; Credit Suisse (Seidel); Oliver Wyman
(Feb. 2012); Oliver Wyman (Dec. 2011). For example, one commenter
stated that because markets and trading volumes are volatile,
consistent profitability and low earnings volatility are outside a
market maker's control. In support of this statement, the commenter
indicated that: (i) customer trading activity varies significantly
with market conditions, which results in volatility in a market
maker's earnings and profitability; and (ii) a market maker will
experience volatility associated with changes in the value of its
inventory positions, and principal risk is a necessary feature of
market making. See Morgan Stanley.
    \1146\ See Oliver Wyman (Feb. 2012); Oliver Wyman (Dec. 2011).
---------------------------------------------------------------------------

    A few commenters indicated that the analysis in the proposed
customer-facing activity factor may not accurately reflect how market
making occurs in certain markets and asset classes due to potential
limitations on interdealer trading.\1147\ According to another
commenter, however, a banking entity's non-customer facing trades
should be required to be matched with existing customer
counterparties.\1148\ With respect to the near term customer demand
component of this factor, one commenter expressed concern that it goes
farther than the statute's activity-based ``design'' test by analyzing
whether a trading unit's inventory has exceeded reasonably expected
near term customer demand at any particular point in time.\1149\
---------------------------------------------------------------------------

    \1147\ See Morgan Stanley; Goldman (Prop. Trading).
    \1148\ See Public Citizen.
    \1149\ See Oliver Wyman (Feb. 2012).
---------------------------------------------------------------------------

    Some commenters expressed concern about the payment of fees,
commissions, and spreads factor.\1150\ One commenter appeared to
support this proposed factor.\1151\ According to one commenter, this
factor fails to recognize that market makers routinely pay a variety of
fees in connection with their market making-related activity,
including, for example, fees to access liquidity on another market to
satisfy customer demand, transaction fees as a matter of course, and
fees in connection with hedging transactions. This commenter also
indicated that, because spreads in current, rapidly-moving markets are
volatile, short-term measurements of profit compared to spread revenue
is problematic, particularly for less liquid

stocks.\1152\ Another commenter stated that this factor reflects a bias
toward agency trading and principal market making in highly liquid,
exchange-traded markets and does not reflect the nature of principal
market making in most markets.\1153\ One commenter recommended that the
rule require that a trader who pays a fee be prepared to document the
chain of custody to show that the instrument is shortly re-sold to an
interested customer.\1154\
---------------------------------------------------------------------------

    \1150\ See NYSE Euronext; Morgan Stanley.
    \1151\ See Public Citizen.
    \1152\ See NYSE Euronext.
    \1153\ See Morgan Stanley.
    \1154\ See Public Citizen.
---------------------------------------------------------------------------

    Regarding the proposed compensation incentives factor, one
commenter requested that the Agencies make clear that explanatory facts
and circumstances cannot justify a trading unit providing compensation
incentives that primarily reward proprietary risk-taking to employees
engaged in market making. In addition, the commenter recommended that
the Agencies delete the word ``primarily'' from this factor.\1155\
---------------------------------------------------------------------------

    \1155\ See Occupy. This commenter also stated that the
commentary in Appendix B stating that a banking entity may give some
consideration of profitable hedging activities in determining
compensation would provide inappropriate incentives. See id.
---------------------------------------------------------------------------

c. Determination To Not Adopt Proposed Appendix B
    To improve clarity, the final rule establishes particular criteria
for the exemption and does not incorporate the commentary in proposed
Appendix B regarding the identification of permitted market making-
related activities. This SUPPLEMENTARY INFORMATION provides guidance on
the standards for compliance with the market-making exemption.
9. Use of Quantitative Measurements
    Consistent with the FSOC study and the proposal, the Agencies
continue to believe that quantitative measurements can be useful to
banking entities and the Agencies to help assess the profile of a
trading desk's trading activity and to help identify trading activity
that may warrant a more in-depth review.\1156\ The Agencies will not
use quantitative measurements as a dispositive tool for differentiating
between permitted market making-related activities and prohibited
proprietary trading. Like the framework the Agencies have developed for
the market-making exemption, the Agencies recognize that there may be
differences in the quantitative measurements across markets and asset
classes.
---------------------------------------------------------------------------

    \1156\ See infra Part IV.C.3.; final rule Appendix A.
---------------------------------------------------------------------------

4. Section ----.5: Permitted Risk-Mitigating Hedging Activities
    Section ----.5 of the proposed rule implemented section 13(d)(1)(C)
of the BHC Act, which provides an exemption from the prohibition on
proprietary trading for certain risk-mitigating hedging
activities.\1157\ Section 13(d)(1)(C) provides an exemption for risk-
mitigating hedging activities in connection with and related to
individual or aggregated positions, contracts, or other holdings of a
banking entity that are designed to reduce the specific risks to the
banking entity in connection with and related to such positions,
contracts, or other holdings (the ``hedging exemption''). Section --
--.5 of the final rule implements the hedging exemption with a number
of modifications from the proposed rule to respond to commenters'
concerns as described more fully below.
---------------------------------------------------------------------------

    \1157\ See 12 U.S.C. 1851(d)(1)(C); proposed rule Sec.  ----.5.
---------------------------------------------------------------------------

a. Summary of Proposal's Approach to Implementing the Hedging Exemption
    The proposed rule would have required seven criteria to be met in
order for a banking entity's activity to qualify for the hedging
exemption. First, Sec. Sec.  ----.5(b)(1) and ----.5(b)(2)(i) of the
proposed rule generally required that the banking entity establish an
internal compliance program that is designed to ensure the banking
entity's compliance with the requirements of the hedging limitations,
including reasonably designed written policies and procedures, internal
controls, and independent testing, and that a transaction for which the
banking entity is relying on the hedging exemption be made in
accordance with the compliance program established under Sec.  --
--.5(b)(1). Next, Sec.  ----.5(b)(2)(ii) of the proposed rule required
that the transaction hedge or otherwise mitigate one or more specific
risks, including market risk, counterparty or other credit risk,
currency or foreign exchange risk, interest rate risk, basis risk, or
similar risks, arising in connection with and related to individual or
aggregated positions, contracts, or other holdings of the banking
entity. Moreover, Sec.  ----.5(b)(2)(iii) of the proposed rule required
that the transaction be reasonably correlated, based upon the facts and
circumstances of the underlying and hedging positions and the risks and
liquidity of those positions, to the risk or risks the transaction is
intended to hedge or otherwise mitigate. Furthermore, Sec.  --
--.5(b)(2)(iv) of the proposed rule required that the hedging
transaction not give rise, at the inception of the hedge, to
significant exposures that are not themselves hedged in a
contemporaneous transaction. Section ----.5(b)(2)(v) of the proposed
rule required that any hedge position established in reliance on the
hedging exemption be subject to continuing review, monitoring and
management. Finally, Sec.  ----.5(b)(2)(vi) of the proposed rule
required that the compensation arrangements of persons performing the
risk-mitigating hedging activities be designed not to reward
proprietary risk-taking. Additionally, Sec.  ----.5(c) of the proposed
rule required the banking entity to document certain hedging
transactions at the time the hedge is established.
b. Manner of Evaluating Compliance With the Hedging Exemption
    A number of commenters expressed concern that the final rule
required application of the hedging exemption on a trade-by-trade
basis.\1158\ One commenter argued that the text of the proposed rule
seemed to require a trade-by-trade analysis because each ``purchase or
sale'' or ``hedge'' was subject to the requirements.\1159\ The final
rule modifies the proposal by generally replacing references to a
``purchase or sale'' in the Sec.  ----.5(b) requirements with ``risk-
mitigating hedging activity.'' The Agencies believe this approach is
consistent with the statute, which refers to ``risk-mitigating hedging
activity.'' \1160\
---------------------------------------------------------------------------

    \1158\ See Ass'n. of Institutional Investors (Feb. 2012); See
also Barclays; ICI (Feb. 2012); Investure; MetLife; RBC; SIFMA et
al. (Prop. Trading) (Feb. 2012); SIFMA (Asset Mgmt.) (Feb. 2012);
Morgan Stanley; Fixed Income Forum/Credit Roundtable; Fidelity; FTN.
    \1159\ See Barclays.
    \1160\ See 12 U.S.C. 1851(d)(1)(C) (stating that ``risk-
mitigating hedging activities'' are permitted under certain
circumstances).
---------------------------------------------------------------------------

    Section 13(d)(1)(C) of the BHC Act specifically authorizes risk-
mitigating hedging activities in connection with and related to
``individual or aggregated positions, contracts or other holdings.''
\1161\ Thus, the statute does not require that exempt hedging be
conducted on a trade-by-trade basis, and permits hedging of aggregated
positions. The Agencies recognized this in the proposed rule, and the
final rule continues to permit hedging activities in connection with
and related to individual or aggregated positions.
---------------------------------------------------------------------------

    \1161\ See 12 U.S.C. 1851(d)(1)(C).
---------------------------------------------------------------------------

    The statute also requires that, to be exempt under section
13(d)(1)(C), hedging activities be risk-mitigating. The final rule
incorporates this statutory requirement. As explained in more detail
below, the final rule requires that, in order to qualify for the
exemption for

risk-mitigating hedging activities: The banking entity implement,
maintain, and enforce an internal compliance program, including
policies and procedures that govern and control these hedging
activities; the hedging activity be designed to reduce or otherwise
significantly mitigate and demonstrably reduces or otherwise
significantly mitigates specific, identifiable risks; the hedging
activity not give rise to significant new risks that are left unhedged;
the hedging activity be subject to continuing review, monitoring and
management to address risk that might develop over time; and the
compensation arrangements for persons performing risk-mitigating
hedging activities be designed not to reward or incentivize prohibited
proprietary trading. These requirements are designed to focus the
exemption on hedging activities that are designed to reduce risk and
that also demonstrably reduce risk, in accordance with the requirement
under section 13(d)(1)(C) that hedging activities be risk-mitigating to
be exempt. Additionally, the final rule imposes a documentation
requirement on certain types of hedges.
    Consistent with the other exemptions from the ban on proprietary
trading for market-making and underwriting, the Agencies intend to
evaluate whether an activity complies with the hedging exemption under
the final rule based on the totality of circumstances involving the
products, techniques, and strategies used by a banking entity as part
of its hedging activity.\1162\
---------------------------------------------------------------------------

    \1162\ See Part IV.A.4.b., infra.
---------------------------------------------------------------------------

c. Comments on the Proposed Rule and Approach to Implementing the
Hedging Exemption
    Commenters expressed a variety of views on the proposal's hedging
exemption. A few commenters offered specific suggestions described more
fully below regarding how, in their view, the hedging exemption should
be strengthened to ensure proper oversight of hedging activities.\1163\
These commenters expressed concern that the proposal's exemption was
too broad and argued that all proprietary trading could be designated
as a hedge under the proposal and thereby evade the prohibition of
section 13.\1164\
---------------------------------------------------------------------------

    \1163\ See, e.g., AFR et al. (Feb. 2012); AFR (June 2013);
Better Markets (Feb. 2012); Sens. Merkley & Levin (Feb. 2012).
    \1164\ See, e.g., Occupy.
---------------------------------------------------------------------------

    By contrast, a number of other commenters argued that the proposal
imposed burdensome requirements that were not required by statute,
would limit the ability of banking entities to hedge in a prudent and
cost-effective manner, and would reduce market liquidity.\1165\ These
commenters argued that implementation of the requirements of the
proposal would decrease safety and soundness of banking entities and
the financial system by reducing cost-effective risk management
options. Some commenters emphasized that the ability of banking
entities to hedge their positions and manage risks taken in connection
with their permissible activities is a critical element of liquid and
efficient markets, and that the cumulative impact of the proposal would
inhibit this risk-mitigation by raising transaction costs and
suppressing essential and beneficial hedging activities.\1166\
---------------------------------------------------------------------------

    \1165\ See, e.g., Australian Bankers' Ass'n (Feb. 2012); BoA;
Barclays; Credit Suisse (Seidel); Goldman (Prop. Trading); HSBC; ICI
(Feb. 2012); Japanese Bankers Ass'n.; JPMC; Morgan Stanley; Chamber
(Feb. 2012); Wells Fargo (Prop. Trading); Rep. Bachus et al.; RBC;
SIFMA et al. (Prop. Trading) (Feb. 2012); See also Stephen Roach.
    \1166\ See Credit Suisse (Seidel); ICI (Feb. 2012); Wells Fargo
(Prop. Trading); See also Banco de M[eacute]xico; SIFMA et al.
(Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); BoA.
---------------------------------------------------------------------------

    A number of commenters expressed concern that the proposal's
hedging exemption did not permit the full breadth of transactions in
which banking entities engage to hedge or mitigate risks, such as
portfolio hedging,\1167\ dynamic hedging,\1168\ anticipatory
hedging,\1169\ or scenario hedging.\1170\ Some commenters stated that
restrictions on a banking entity's ability to hedge may have a chilling
effect on its willingness to engage in other permitted activities, such
as market making.\1171\ In addition, many of these commenters stated
that, if a banking entity is limited in its ability to hedge its
market-making inventory, it may be less willing or able to assume risk
on behalf of customers or provide financial products to customers that
are used for hedging purposes. As a result, according to these
commenters, it will be more difficult for customers to hedge their
risks and customers may be forced to retain risk.\1172\
---------------------------------------------------------------------------

    \1167\ See MetLife; SIFMA et al. (Prop. Trading) (Feb. 2012);
Morgan Stanley; Barclays; Goldman (Prop. Trading); BoA; ABA; HSBC;
Fixed Income Forum/Credit Roundtable; ICI (Feb. 2012); ISDA (Feb.
2012).
    \1168\ See Goldman (Prop. Trading); BoA.
    \1169\ See Barclays; State Street (Feb. 2012); SIFMA et al.
(Prop. Trading) (Feb. 2012); Japanese Bankers Ass'n.; Credit Suisse
(Seidel); BoA; PNC et al.; ISDA (Feb. 2012).
    \1170\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC;
Goldman (Prop. Trading); BoA; Comm. on Capital Markets Regulation.
Each of these types of activities is discussed further below. See
infra Part IV.A.4.d.2.
    \1171\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit
Suisse (Seidel); Barclays; Goldman (Prop. Trading); BoA.
    \1172\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman
(Prop. Trading); Credit Suisse (Seidel).
---------------------------------------------------------------------------

    Another commenter contended that the proposal represented an
inappropriate ``one-size-fits-all'' approach to hedging that did not
properly take into account the way banking entities and especially
market intermediaries operate, particularly in less-liquid
markets.\1173\ Two commenters requested that the Agencies clarify that
a banking entity may use its discretion to choose any hedging strategy
that meets the requirements of the proposed exemption and, in
particular, that a banking entity is not obligated to choose the ``best
hedge'' and may use the cheapest instrument available.\1174\ One
commenter suggested uncertainty about the permissibility of a situation
where gains on a hedge position exceed losses on the underlying
position. The commenter suggested that uncertainty may lead banking
entities to not use the most cost-effective hedge, which would make
hedging less efficient and raise costs for banking entities and
customers.\1175\ However, another commenter expressed concern about
banking entities relying on the cheapest satisfactory hedge. The
commenter explained that such hedges lead to more complicated risk
profiles and require banking entities to engage in additional
transactions to hedge the exposures resulting from the imperfect,
cheapest hedge.\1176\
---------------------------------------------------------------------------

    \1173\ See Barclays.
    \1174\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit
Suisse (Seidel).
    \1175\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1176\ See Occupy.
---------------------------------------------------------------------------

    A few commenters suggested the hedging exemption be modified in
favor of a simpler requirement that banking entities adopt risk limits
and policies and procedures commensurate with qualitative guidance
issued by the Agencies.\1177\ Many of these commenters also expressed
concerns that the proposed rule's hedging exemption would not allow so-
called asset-liability management (``ALM'') activities.\1178\ Some
commenters proposed that the risk-mitigating hedging exemption
reference a set of relevant descriptive factors rather than

specific prescriptive requirements.\1179\ Other alternative frameworks
suggested by commenters include: (i) Reformulating the proposed
requirements as supervisory guidance; \1180\ (ii) establishing a safe
harbor,\1181\ presumption of compliance,\1182\ or bright line test;
\1183\ or (iii) a principles-based approach that would require a
banking entity to document its risk-mitigating hedging strategies for
submission to its regulator.\1184\
---------------------------------------------------------------------------

    \1177\ See BoA; Barclays; CH/ABASA; Credit Suisse (Seidel);
HSBC; ICI (Feb. 2012); ISDA (Apr. 2012); JPMC; Morgan Stanley; PNC;
SIFMA et al. (Prop. Trading) (Feb. 2012); See also Stephen Roach.
    \1178\ A detailed discussion of ALM activities is provided in
Part IV.A.1.d.2 of this SUPPLEMENTARY INFORMATION relating to the
definition of trading account. As explained in that part, the final
rule does not allow use of the hedging exemption for ALM activities
that are outside of the hedging activities specifically permitted by
the final rule.
    \1179\ See BoA; JPMC; Morgan Stanley.
    \1180\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; PNC
et al.; ICI.
    \1181\ See Prof. Richardson; ABA (Keating).
    \1182\ See Barclays; BoA; ISDA (Feb. 2012).
    \1183\ See Johnson & Prof. Stiglitz.
    \1184\ See HSBC.
---------------------------------------------------------------------------

d. Final Rule
    The final rule provides a multi-faceted approach to implementing
the hedging exemption that seeks to ensure that hedging activity is
designed to be risk-reducing in nature and not designed to mask
prohibited proprietary trading.\1185\ The final rule includes a number
of modifications in response to comments.
---------------------------------------------------------------------------

    \1185\ See final rule Sec.  ----.5.
---------------------------------------------------------------------------

    This multi-faceted approach is intended to permit hedging
activities that are risk-mitigating and to limit potential abuse of the
hedging exemption while not unduly constraining the important risk-
management function that is served by a banking entity's hedging
activities. This approach is also intended to ensure that any banking
entity relying on the hedging exemption has in place appropriate
internal control processes to support its compliance with the terms of
the exemption. While commenters proposed a number of alternative
frameworks for the hedging exemption, the Agencies believe the final
rule's multi-faceted approach most effectively balances commenter
concerns with statutory purpose. In response to commenter requests to
reformulate the proposed rule as supervisory guidance,\1186\ including
the suggestion that the Agencies simply require banking entities to
adopt risk limits and policies and procedures commensurate with
qualitative Agency guidance,\1187\ the Agencies believe that such an
approach would provide less clarity than the adopted approach. Although
a purely guidance-based approach could provide greater flexibility, it
would also provide less specificity, which could make it difficult for
banking entity personnel and the Agencies to determine whether an
activity complies with the rule and could lead to an increased risk of
evasion of the statutory requirements. Further, while a bright-line or
safe harbor approach to the hedging exemption would generally provide a
high degree of certainty about whether an activity qualifies for the
exemption, it would also provide less flexibility to recognize the
differences in hedging activity across markets and asset classes.\1188\
In addition, the use of any bright-line approach would more likely be
subject to gaming and avoidance as new products and types of trading
activities are developed than other approaches to implementing the
hedging exemption. Similarly, the Agencies decline to establish a
presumption of compliance because, in light of the constant innovation
of trading activities and the differences in hedging activity across
markets and asset classes, establishing appropriate parameters for a
presumption of compliance with the hedging exemption would potentially
be less capable of recognizing these legitimate differences than our
current approach.\1189\ Moreover, the Agencies decline to follow a
principles-based approach requiring a banking entity to document its
hedging strategies for submission to its regulator.\1190\ The Agencies
believe that evaluating each banking entity's trading activity based on
an individualized set of documented hedging strategies could be
unnecessarily burdensome and result in unintended competitive impacts
since banking entities would not be subject to one uniform rule. The
Agencies believe the multi-faceted approach adopted in the final rule
establishes a consistent framework applicable to all banking entities
that will reduce the potential for such adverse impacts.
---------------------------------------------------------------------------

    \1186\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; PNC
et al.; ICI (Feb. 2012); BoA; Morgan Stanley.
    \1187\ See BoA; Barclays; CH/ABASA; Credit Suisse (Seidel);
HSBC; ICI (Feb. 2012); ISDA (Apr. 2012); JPMC; Morgan Stanley; PNC;
SIFMA et al. (Prop. Trading) (Feb. 2012); See also Stephen Roach.
    \1188\ Some commenters requested that the Agencies establish a
safe harbor. See Prof. Richardson; ABA (Keating). One commenter
requested that the Agencies adopt a bright-line test. See Johnson &
Prof. Stiglitz.
    \1189\ A few commenters requested that the Agencies establish a
presumption of compliance. See Barclays; BoA; ISDA (Feb. 2012).
    \1190\ One commenter suggested this principles-based approach.
See HSBC.
---------------------------------------------------------------------------

    Further, the Agencies believe the scope of the final hedging
exemption is appropriate because it permits risk-mitigating hedging
activities, as mandated by section 13 of the BHC Act,\1191\ while
requiring a robust compliance program and other internal controls to
help ensure that only genuine risk-mitigating hedges can be used in
reliance on the exemption.\1192\ In response to concerns that the
proposed hedging exemption would reduce legitimate hedging activity and
thus impact market liquidity and the banking entity's willingness to
engage in permissible customer-related activity,\1193\ the Agencies
note that the requirements of the final hedging exemption are designed
to permit banking entities to properly mitigate specific risk
exposures, consistent with the statute. In addition, hedging related to
market-making activity conducted by a market-making desk is subject to
the requirements of the market-making exemption, which are designed to
permit banking entities to continue providing valuable intermediation
and liquidity services, including related risk-management
activity.\1194\ Thus, the final hedging exemption will not negatively
impact the safety and soundness of banking entities or the financial
system or have a chilling effect on a banking entity's willingness to
engage in other permitted activities, such as market making.\1195\
---------------------------------------------------------------------------

    \1191\ Section 13(d)(1)(C) of the BHC Act permits ``risk-
mitigating hedging activities in connection with and related to
individual or aggregated positions, contracts, or other holdings of
a banking entity that are designed to reduce the specific risks to
the banking entity in connection with and related to such positions,
contracts, or other holdings.'' 12 U.S.C. 1851(d)(1)(C).
    \1192\ Some commenters were concerned that the proposed hedging
exemption was too broad and that all proprietary trading could be
designated as a hedge. See, e.g., Occupy.
    \1193\ See, e.g., Australian Bankers Ass'n. (Feb. 2012).; BoA;
Barclays; Credit Suisse (Seidel); Goldman (Prop. Trading); HSBC;
Japanese Bankers Ass'n.; JPMC; Morgan Stanley; Chamber (Feb. 2012);
Wells Fargo (Prop. Trading); Rep. Bachus et al.; RBC; SIFMA et al.
(Prop. Trading) (Feb. 2012).
    \1194\ See supra Part IV.A.3.c.4.
    \1195\ Some commenters believed that restrictions on hedging
would have a chilling effect on banking entities' willingness to
engage in market making, and may result in customers experiencing
difficulty in hedging their risks or force customers to retain risk.
See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit Suisse
(Seidel); Barclays; Goldman (Prop. Trading); BoA; IHS.
---------------------------------------------------------------------------

    These limits and requirements are designed to prevent the type of
activity conducted by banking entities in the past that involved taking
large positions using novel strategies to attempt to profit from
potential effects of general economic or market developments and
thereby potentially offset the general effects of those events on the
revenues or profits of the banking entity. The documentation
requirements in the final rule support these limits by identifying
activity that occurs in reliance on the risk-mitigating hedging
exemption at an organizational level or desk that is not responsible
for establishing the risk or positions being hedged.

1. Compliance Program Requirement
    The first criterion of the proposed hedging exemption required a
banking entity to establish an internal compliance program designed to
ensure the banking entity's compliance with the requirements of the
hedging exemption and conduct its hedging activities in compliance with
that program. While the compliance program under the proposal was
expected to be appropriate for the size, scope, and complexity of each
banking entity's activities and structure, the proposal would have
required each banking entity with significant trading activities to
implement robust, detailed hedging policies and procedures and related
internal controls and independent testing designed to prevent
prohibited proprietary trading in the context of permitted hedging
activity.\1196\ These enhanced programs for banking entities with large
trading activity were expected to include written hedging policies at
the trading unit level and clearly articulated trader mandates for each
trader designed to ensure that hedging strategies mitigated risk and
were not for the purpose of engaging in prohibited proprietary trading.
---------------------------------------------------------------------------

    \1196\ These aspects of the compliance program requirement are
described in further detail in Part IV.C. of this SUPPLEMENTARY
INFORMATION.
---------------------------------------------------------------------------

    Commenters, including industry groups, generally expressed support
for requiring policies and procedures to monitor the safety and
soundness, as well as appropriateness, of hedging activity.\1197\ Some
of these commenters advocated that the final rule presume that a
banking entity is in compliance with the hedging exemption if the
banking entity's hedging activity is done in accordance with the
written policies and procedures required under its compliance
program.\1198\ One commenter represented that the proposed compliance
framework was burdensome and complex.\1199\
---------------------------------------------------------------------------

    \1197\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1198\ See BoA; Barclays; HSBC; JPMC; Morgan Stanley; See also
Goldman (Prop. Trading); RBC; Barclays; ICI (Feb. 2012); ISDA (Apr.
2012); PNC; SIFMA et al. (Prop. Trading) (Feb. 2012). See the
discussion of why the Agencies decline to take a presumption of
compliance approach above.
    \1199\ See Barclays.
---------------------------------------------------------------------------

    Other commenters expressed concerns that the hedging exemption
would be too limiting and burdensome for community and regional
banks.\1200\ Some commenters argued that foreign banking entities
should not be subject to the requirements of the hedging exemption for
transactions that do not introduce risk into the U.S. financial
system.\1201\ Other commenters stated that coordinated hedging through
and by affiliates should qualify as permitted risk-mitigating hedging
activity.\1202\
---------------------------------------------------------------------------

    \1200\ See ICBA; M&T Bank.
    \1201\ See, e.g., Bank of Canada; Allen & Overy (on behalf of
Canadian Banks). Additionally, foreign banking entities engaged in
hedging activity may be able to rely on the exemption for trading
activity conducted by foreign banking entities in lieu of the
hedging exemption, provided they meet the requirements of the
exemption for trading by foreign banking entities under Sec.  --
--.6(e) of the final rule. See infra Part IV.A.8.
    \1202\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.
---------------------------------------------------------------------------

    Some commenters urged the Agencies to adopt detailed limitations on
hedging activities. For example, one commenter urged that all hedging
trades be labeled as such at the inception of the trade and detailed
information regarding the trader, manager, and supervisor authorizing
the trade be kept and reviewed.\1203\ Another commenter suggested that
the hedging exemption contain a requirement that the banking entity
employee who approves a hedge affirmatively certify that the hedge
conforms to the requirements of the rule and has not been put in place
for the direct or indirect purpose or effect of generating speculative
profits.\1204\ A few commenters requested limitations on instruments
that can be used for hedging purposes.\1205\
---------------------------------------------------------------------------

    \1203\ See Sens. Merkley & Levin (Feb. 2012).
    \1204\ See Better Markets (Feb. 2012).
    \1205\ See Sens. Merkley & Levin (Feb. 2012); Occupy; Andrea
Psoras.
---------------------------------------------------------------------------

    The final rule retains the proposal's requirement that a banking
entity establish an internal compliance program that is designed to
ensure the banking entity limits its hedging activities to hedging that
is risk-mitigating.\1206\ The final rule largely retains the proposal's
approach to the compliance program requirement, except to the extent
that, as requested by some commenters,\1207\ the final rule modifies
the proposal to provide additional detail regarding the elements that
must be included in a compliance program. Similar to the proposal, the
final rule contemplates that the scope and detail of a compliance
program will reflect the size, activities, and complexity of banking
entities in order to ensure that banking entities engaged in more
active trading have enhanced compliance programs without imposing undue
burden on smaller organizations and entities that engage in little or
no trading activity.\1208\ The final rule also requires, like the
proposal, that the banking entity implement, maintain, and enforce the
program.\1209\
---------------------------------------------------------------------------

    \1206\ See final rule Sec.  ----.5(b)(1). The final rule retains
the proposal's requirement that the compliance program include,
among other things, written hedging policies.
    \1207\ See, e.g., BoA; ICI (Feb. 2012); ISDA (Feb. 2012); JPMC;
Morgan Stanley; PNC; SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1208\ See final rule Sec.  ----.20(a) (stating that ``[t]he
terms, scope and detail of [the] compliance program shall be
appropriate for the types, size, scope and complexity of activities
and business structure of the banking entity''). The Agencies
believe this helps address some commenters' concern that the hedging
exemption would be too limiting and burdensome for community and
regional banks. See ICBA; M&T Bank.
    \1209\ Many of these policies and procedures were contained as
part of the proposed rule's compliance program requirements under
Appendix C. They have been moved, and in some cases modified, in
order to more clearly demonstrate how they are incorporated into the
requirements of the hedging exemption.
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    In response to commenter concerns about ensuring the appropriate
level of senior management involvement in establishing these
policies,\1210\ the final rule requires that the written policies and
procedures be developed and implemented by a banking entity at the
appropriate level of organization and expressly address the banking
entity's requirements for escalation procedures, supervision, and
governance related to hedging activities.\1211\
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    \1210\ See Better Markets (Feb. 2012). The final rule does not
require affirmative certification of each hedge, as suggested by
this commenter, because the Agencies believe it would unnecessarily
slow legitimate transactions. The Agencies believe the final rule's
required management framework and escalation procedures achieve the
same objective as the commenter's suggested approach, while imposing
fewer burdens on legitimate risk-mitigating hedging activity.
    \1211\ See final rule Sec. Sec.  ----.20(b), ----.5(b). This
approach builds on the proposal's requirement that senior management
and intermediate managers be accountable for the effective
implementation of the compliance program.
---------------------------------------------------------------------------

    Like the proposal, the final rule specifies that a banking entity's
compliance regime must include reasonably designed written policies and
procedures regarding the positions, techniques and strategies that may
be used for hedging, including documentation indicating what positions,
contracts or other holdings a trading desk may use in its risk-
mitigating hedging activities.\1212\ The

focus on policies and procedures governing risk identification and
mitigation, analysis and testing of position limits and hedging
strategies, and internal controls and ongoing monitoring is expected to
limit use of the hedging exception to risk-mitigating hedging. The
final rule adds to the proposed compliance program approach by
requiring that the banking entity's written policies and procedures
include position and aging limits with respect to such positions,
contracts, or other holdings.\1213\ The final rule, similar to the
proposed rule, also requires that the compliance program contain
internal controls and ongoing monitoring, management, and authorization
procedures, including relevant escalation procedures.\1214\ Further,
the final rule retains the proposed requirement that the compliance
program provide for the conduct of analysis and independent testing
designed to ensure that the positions, techniques, and strategies that
may be used for hedging may reasonably be expected to demonstrably
reduce or otherwise significantly mitigate the specific, identifiable
risks being hedged.\1215\
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    \1212\ This approach is generally consistent with some
commenters' suggested approach of limiting the instruments that can
be used for hedging purposes; although the final rules provide
banking entities with discretion to determine the types of
positions, contracts, or other holdings that will mitigate specific
risks of individual or aggregated holdings and thus may be used for
risk-mitigating hedging activity. See Sens. Merkley & Levin (Feb.
2012); Occupy; Andrea Psoras. In response to one commenter's request
that the final rule require all hedges to be labeled at inception
and certain detailed information be documented for each hedge, the
Agencies note that the final rules continue to require detailed
documentation for hedging activity that presents a heightened risk
of evasion. See Sens. Merkley & Levin (Feb. 2012); final rule Sec.
----.5(c); infra Part IV.A.4.d.4. The Agencies believe a
documentation requirement targeted at these scenarios balances the
need to prevent evasion of the general prohibition on proprietary
trading with the concern that documentation requirements can slow or
impede legitimate risk-mitigating activity in the normal course.
    \1213\ See final rule Sec.  ----.5(b)(1)(i). Some commenters
expressed support for the use of risk limits in determining whether
trading activity qualifies for the hedging exemption. See, e.g.,
Barclays; Credit Suisse (Seidel); ICI (Feb. 2012); Morgan Stanley.
    \1214\ See final rule Sec.  ----.5(b)(1)(ii).
    \1215\ See final rule Sec.  ----.5(b)(1)(iii). The final rule's
requirement to demonstrably reduce or otherwise significantly
mitigate is discussed in greater detail below.
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    The final rule also adds that correlation analysis be undertaken as
part of the analysis of the hedging positions, techniques, and
strategies that may be used. This provision effectively changes the
requirement in the proposed rule that the hedge must maintain
correlation into a requirement that correlation be analyzed as part of
the compliance program before a hedging activity is undertaken. This
provision incorporates the concept in the proposed rule that a hedge
should be correlated (negatively, when sign is considered) to the risk
being hedged. However, the Agencies recognize that some effective
hedging activities, such as deep out-of-the-money puts and calls, may
not be exhibit a strong linear correlation to the risks being hedged
and also that correlation over a period of time between two financial
positions does not necessarily mean one position will in fact reduce or
mitigate a risk of the other. Rather, the Agencies expect the banking
entity to undertake a correlation analysis that will, in many but not
all instances, provide a strong indication of whether a potential
hedging position, strategy, or technique will or will not demonstrably
reduce the risk it is designed to reduce. It is important to recognize
that the rule does not require the banking entity to prove correlation
mathematically or by other specific methods. Rather, the nature and
extent of the correlation analysis undertaken would be dependent on the
facts and circumstances of the hedge and the underlying risks targeted.
If correlation cannot be demonstrated, then the Agencies would expect
that such analysis would explain why not and also how the proposed
hedging position, technique, or strategy is designed to reduce or
significantly mitigate risk and how that reduction or mitigation can be
demonstrated without correlation.
    Moreover, the final rule requires hedging activity conducted in
reliance on the hedging exemption be subject to continuing review,
monitoring, and management that is consistent with the banking entity's
written hedging policies and procedures and is designed to reduce or
otherwise significantly mitigate, and demonstrably reduces or otherwise
significantly mitigates, the specific, identifiable risks that develop
over time from hedging activity and underlying positions.\1216\ This
ongoing review should consider market developments, changes in
positions or the configuration of aggregated positions, changes in
counterparty risk, and other facts and circumstances related to the
risks associated with the underlying and hedging positions, contracts,
or other holdings.
---------------------------------------------------------------------------

    \1216\ The proposal also contained a continuing review,
monitoring, and management requirement. See proposed rule Sec.  --
--.5(b)(2)(v). The final rule modifies the proposed requirement,
however, by removing the ``reasonable correlation'' requirement and
instead requiring that the hedge demonstrably reduce or otherwise
significantly mitigate specific identifiable risks. Correlation
analysis is, however, a necessary component of the analysis element
in the compliance program requirement of the hedging exemption in
the final rule. See final rule Sec.  ----.5(b). This change is
discussed below.
---------------------------------------------------------------------------

    The Agencies believe that requiring banking entities to develop and
follow detailed compliance policies and procedures related to risk-
mitigating hedging activity will help both banking entities and
examiners understand the risks to which banking entities are exposed
and how these risks are managed in a safe and sound manner. With this
increased understanding, banking entities and examiners will be better
able to evaluate whether banking entities are engaged in legitimate,
risk-reducing hedging activity, rather than impermissible proprietary
trading. While the Agencies recognize there are certain costs
associated with this compliance program requirement,\1217\ we believe
this provision is necessary to ensure compliance with the statute and
the final rule. As discussed in Part IV.C.1., the Agencies have
modified the proposed compliance program structure to reduce burdens on
small banking entities.\1218\
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    \1217\ See Barclays.
    \1218\ See infra Part IV.C.1. Some commenters expressed concern
that the compliance program requirement would place undue burden on
regional or community banks. See ICBA; M&T Bank.
---------------------------------------------------------------------------

    The Agencies note that hedging may occur across affiliates under
the hedging exemption.\1219\ To ensure that hedging across trading
desks or hedging done at a level of the organization outside of the
trading desk does not result in prohibited proprietary trading, the
final rule imposes enhanced documentation requirements on these
activities, which are discussed more fully below. The Agencies also
note that nothing in the final rule limits or restricts the ability of
the appropriate supervisory agency of a banking entity to place limits
on interaffiliate hedging in a manner consistent with their safety and
soundness authority to the extent the agency has such authority.\1220\
Additionally, nothing in the final rule limits or modifies the
applicability of CFTC regulations with respect to the clearing of
interaffiliate swaps.\1221\
---------------------------------------------------------------------------

    \1219\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.
    \1220\ In addition, section 608 of the Dodd-Frank Act added
credit exposure arising from securities borrowing and lending or a
derivative transaction with an affiliate to the list of covered
transactions subject to the restrictions of section 23A of the FR
Act, in each case to the extent that such transaction causes a bank
to have credit exposure to the affiliate. See 12 U.S.C. 371c(b)(7)
and (8). As a consequence, interaffiliate hedging activity within a
banking entity may be subject to limitation or restriction under
section 23A of the FR Act.
    \1221\ See 17 CFR 50.52.
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2. Hedging of Specific Risks and Demonstrable Reduction of Risk
    Section ----.5(b)(2)(ii) of the proposed rule required that a
qualifying transaction hedge or otherwise mitigate one or more specific
risks, including market risk, counterparty or other credit risk,
currency or foreign exchange risk, interest rate risk, basis risk, or
similar risks, arising in connection with and related to individual or
aggregated positions, contracts, or other holdings of a banking
entity.\1222\ This criterion

implemented the essential element of the hedging exemption that the
transaction be risk-mitigating.
---------------------------------------------------------------------------

    \1222\ See proposed rule Sec.  ----.5(b)(2)(ii); See also Joint
Proposal, 76 FR 68,875.
---------------------------------------------------------------------------

    Some commenters expressed support for this provision, particularly
the requirement that a banking entity be able to tie a hedge to a
specific risk.\1223\ One of these commenters stated that a demonstrated
reduction in risk should be a key indicator of whether a hedge is in
fact permitted.\1224\ However, some commenters argued that the list of
risks eligible to be hedged under the proposed rule, which included
risks arising from aggregated positions, could justify transactions
that should be viewed as prohibited proprietary trading.\1225\ Another
commenter contended that the term ``basis risk'' was undefined and
could heighten the potential that this exemption would be used to evade
the prohibition on proprietary trading.\1226\
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    \1223\ See AFR (June 2013); Sens. Merkley & Levin (Feb. 2012);
Public Citizen; Johnson & Prof. Stiglitz.
    \1224\ See Sens. Merkley & Levin (Feb. 2012).
    \1225\ See Public Citizen; See also Occupy.
    \1226\ See Occupy.
---------------------------------------------------------------------------

    Other commenters argued that requiring a banking entity to specify
the particular risk being hedged discourages effective hedging and
increases the risk at banking entities. These commenters contended that
hedging activities must address constantly changing positions and
market conditions.\1227\ Another commenter argued that this requirement
could render a banking entity's hedges impermissible if those hedges do
not succeed in fully hedging or mitigating an identified risk as
determined by a post hoc analysis and could prevent banking entities
from entering into hedging transactions in anticipation of risks that
the banking entity expects will arise (or increase).\1228\ Certain
commenters requested that the hedging exemption provide a safe harbor
for positions that satisfy FASB ASC Topic 815 (formerly FAS 133)
hedging accounting standards, which provides that an entity recognize
derivative instruments, including certain derivative instruments
embedded in other contracts, as assets or liabilities in the statement
of financial position and measure them at fair value.\1229\ Another
commenter suggested that scenario hedges could be identifiable and
subject to review by the Agencies using VaR, Stress VaR, and VaR
Exceedance, as well as revenue metrics.\1230\
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    \1227\ See, e.g., Japanese Bankers Ass'n.
    \1228\ See Barclays.
    \1229\ See ABA (Keating); Wells Fargo (Prop. Trading). Although
certain accounting standards, such as FASB ASC Topic 815 hedge
accounting standards, address circumstances in which a transaction
may be considered a hedge of another transaction, the final rule
does not refer to or expressly rely on these accounting standards
because such standards: (i) Are designed for financial statement
purposes, not to identify proprietary trading; and (ii) change often
and are likely to change in the future without consideration of the
potential impact on section 13 of the BHC Act.
    \1230\ See JPMC.
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    The Agencies have considered these comments carefully in light of
the statute. Section 13(d)(1)(C) of the BHC Act provides an exemption
from the prohibition on proprietary trading only for hedging activity
that is ``designed to reduce the specific risks to the banking entity
in connection with and related to'' individual or aggregated positions,
contracts, or other holdings of the banking entity.\1231\ Thus, while
the statute permits hedging of individual or aggregated positions (as
discussed more fully below), the statute requires that, to be exempt
from the prohibition on proprietary trading, hedging transactions be
designed to reduce specific risks.\1232\ Moreover, it requires that
these specific risks be in connection with or related to the individual
or aggregated positions, contracts, or other holdings of the banking
entity.
---------------------------------------------------------------------------

    \1231\ 12 U.S.C. 1851(d)(1)(C).
    \1232\ Some commenters expressed support for the requirement
that a banking entity tie a hedge to a specific risk. See AFR (June
2012); Sens. Merkley & Levin (Feb. 2012); Public Citizen; Johnson &
Prof. Stiglitz.
---------------------------------------------------------------------------

    The final rule implements these requirements. To ensure that exempt
hedging activities are designed to reduce specific risks, the final
rule requires that the hedging activity at inception of the hedging
activity, including, without limitation, any adjustments to the hedging
activity, be designed to reduce or otherwise significantly mitigate and
demonstrably reduces or otherwise significantly mitigates one or more
specific, identifiable risks, including market risk, counterparty or
other credit risk, currency or foreign exchange risk, interest rate
risk, commodity price risk, basis risk, or similar risks, arising in
connection with and related to identified individual or aggregated
positions, contracts, or other holdings of the banking entity, based
upon the facts and circumstances of the individual or aggregated
underlying and hedging positions, contracts, or other holdings of the
banking entity and the risks and liquidity thereof.\1233\ Hedging
activities and limits should be based on analysis conducted by the
banking entity of the appropriateness of hedging instruments,
strategies, techniques, and limits. As discussed above, this analysis
must include analysis of correlation between the hedge and the specific
identifiable risk or risks that the hedge is designed to reduce or
significantly mitigate.\1234\
---------------------------------------------------------------------------

    \1233\ See final rule Sec.  ----.5(b)(2)(ii).
    \1234\ See final rule Sec.  ----.5(b)(1)(iii).
---------------------------------------------------------------------------

    This language retains the focus of the statute and the proposed
rule on reducing or mitigating specific and identified risks.\1235\ As
discussed more fully above, banking entities are required to describe
in their compliance policies and procedures the types of strategies,
techniques, and positions that may be used for hedging.
---------------------------------------------------------------------------

    \1235\ Some commenters represented that the proposed list of
risks eligible to be hedged could justify transactions that should
be considered proprietary trading. See Public Citizen; Occupy. One
commenter was concerned about the proposed inclusion of ``basis
risk'' in this list. See Occupy. As noted in the proposal, the
Agencies believe the inclusion of a list of eligible risks,
including basis risk, helps implement the essential element of the
statutory hedging exemption--i.e., that the transaction is risk-
reducing in connection with a specific risk. See Joint Proposal, 76
FR 68,875. See also 12 U.S.C. 1851(d)(1)(C). Further, the Agencies
believe the other requirements of the final hedging exemption,
including requirements regarding internal controls and a compliance
program, help to ensure that only legitimate hedging activity
qualifies for the exemption.
---------------------------------------------------------------------------

    The final rule does not prescribe the hedging strategy that a
banking entity must employ. While one commenter urged that the final
rule require each banking entity to adopt the ``best hedge'' for every
transaction,\1236\ the Agencies believe that the complexity of
positions, market conditions at the time of a transaction, availability
of hedging transactions, costs of hedging, and other circumstances at
the time of the transaction make a requirement that a banking entity
always adopt the ``best hedge'' impractical, unworkable, and
subjective.
---------------------------------------------------------------------------

    \1236\ See, e.g., Occupy.
---------------------------------------------------------------------------

    Nonetheless, the statute requires that, to be exempt under section
13(d)(1)(C), hedging activity must be risk-mitigating. To ensure that
only risk-mitigating hedging is permitted under this exemption, the
final rule requires that in its written policies and procedures the
banking entity identify the instruments and positions that may be used
in hedging, the techniques and strategies the banking entity deems
appropriate for its hedging activities, as well as position limits and
aging limits on hedging positions. These written policies and
procedures also must specify the escalation and approval procedures