\530\ See, e.g., Sens. Merkley & Levin (Feb. 2012); John Reed;
Prof. Richardson; Johnson & Prof. Stiglitz; Capital Group; Invesco;
BDA (Feb. 2012) (Oct. 2012) (suggesting a safe harbor for any
trading desk that effects more than 50 percent of its transactions
through sales representatives).
    \531\ See, e.g., Flynn & Fusselman; Prof. Colesanti et al.
    \532\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); IIF;
NYSE Euronext; Credit Suisse (Seidel); JPMC; Barclays; BoA; Wells
Fargo (Prop. Trading) (suggesting that the rule: (i) Provide a
general grant of authority to engage in any transactions entered
into as part of a banking entity's market-making business, where
``market making'' is defined as ``the business of being willing to
facilitate customer purchases and sales of [financial instruments]
as an intermediary over time and in size, including by holding
positions in inventory;'' and (ii) allow banking entities to monitor
compliance with this exemption internally through their compliance
and risk management infrastructure); PNC et al.; Oliver Wyman (Feb.
2012).
    \533\ See, e.g., Goldman (Prop. Trading); Morgan Stanley;
Barclays; Wellington; CalPERS; BlackRock; SSgA (Feb. 2012); Invesco.
    \534\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012)
(suggesting that this guidance could be incorporated in banking
entities' policies and procedures for purposes of complying with the
rule, in addition to the establishment of risk limits, controls, and
metrics); JPMC; BoA; PUC Texas; SSgA (Feb. 2012); PNC et al.; Wells
Fargo (Prop. Trading).
    \535\ See, e.g., Japanese Bankers Ass'n.; Citigroup (Feb. 2012).
    \536\ See, e.g., Morgan Stanley; Stephen Roach.
    \537\ See, e.g., Prof. Duffie; CalPERS; STANY; ICE; Vanguard;
Capital Group.
    \538\ See MetLife; Fixed Income Forum/Credit Roundtable; ACLI
(Feb. 2012).
    \539\ See, e.g., Prof. Duffie; Shadow Fin. Regulatory Comm. See
also Wedbush.
    \540\ See WR Hambrecht.
    \541\ See G2 FinTech.
    \542\ See ISDA (Feb. 2012); ISDA (Apr. 2012).
    \543\ See Sens. Merkley & Levin (Feb. 2012) (stating that the
exemption should expressly mention the conflicts provision and
provide examples to warn against particular conflicts, such as
recommending clients buy poorly performing assets in order to remove
them from the banking entity's book or attempting to move market
prices in favor of trading positions a banking entity has built up
in order to make a profit); Stephen Roach (suggesting that the
exemption integrate the limitations on permitted activities).
    \544\ See Fidelity (stating that the exemption needs to be as
broad as possible to account for customer-facing principal trades,
block trades, and market making in OTC derivatives). See also STANY
(stating that it is better to make the exemption too broad than too
narrow).
---------------------------------------------------------------------------

b. Comments Regarding the Potential Market Impact of the Proposed
Exemption
    As discussed above, several commenters stated that the proposed
rule would impact a banking entity's ability to engage in market
making-related activity. Many of these commenters represented that, as
a result, the proposed exemption would likely result in reduced
liquidity,\545\

wider bid-ask spreads,\546\ increased market volatility,\547\ reduced
price discovery or price transparency,\548\ increased costs of raising
capital or higher financing costs,\549\ greater costs for investors or
consumers,\550\ and slower execution times.\551\ Some commenters
expressed particular concern about potential impacts on institutional
investors (e.g., mutual funds and pension funds) \552\ or on small or
midsized companies.\553\ A number of commenters discussed the
interrelationship between primary and secondary market activity and
indicated that restrictions on market making would impact the
underwriting process.\554\
---------------------------------------------------------------------------

    \545\ See, e.g., AllianceBernstein; Rep. Bachus et al. (Dec.
2011); EMTA; NASP; Wellington; Japanese Bankers Ass'n.; Sen. Hagan;
Prof. Duffie; Investure; Standish Mellon; IR&M MetLife; Lord
Abbett; Commissioner Barnier; Quebec; IIF; Sumitomo Trust; Liberty
Global; NYSE Euronext; CIEBA; EFAMA; SIFMA et al. (Prop. Trading)
(Feb. 2012); Credit Suisse (Seidel); JPMC; Morgan Stanley; Barclays;
Goldman (Prop. Trading); BoA; Citigroup (Feb. 2012); STANY; ICE;
BlackRock; SIFMA (Asset Mgmt.) (Feb. 2012); BDA (Feb. 2012); Putnam;
Fixed Income Forum/Credit Roundtable; Western Asset Mgmt.; ACLI
(Feb. 2012); IAA; CME Group; Wells Fargo (Prop. Trading); Abbott
Labs et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012); T.
Rowe Price; Australian Bankers Ass'n. (Feb. 2012); FEI; AFMA; Sen.
Carper et al.; PUC Texas; ERCOT; IHS; Columbia Mgmt.; SSgA (Feb.
2012); PNC et al.; Eaton Vance; Fidelity; ICI (Feb. 2012); British
Bankers' Ass'n.; Comm. on Capital Markets Regulation; Union Asset;
Sen. Casey; Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012)
(providing estimated impacts on asset valuation, borrowing costs,
and transaction costs in the corporate bond market based on
hypothetical liquidity reduction scenarios); Thakor Study. The
Agencies respond to comments regarding the potential market impact
of the rule in Part IV.A.3.b.3., infra.
    \546\ See, e.g., AllianceBernstein; Wellington; Investure;
Standish Mellon; MetLife; Lord Abbett; Barclays; Goldman (Prop.
Trading); Citigroup (Feb. 2012); BlackRock; Putnam; ACLI (Feb.
2012); Abbott Labs et al. (Feb. 14, 2012); Abbott Labs et al. (Feb.
21, 2012); T. Rowe Price; Sen. Carper et al.; IHS; Columbia Mgmt.;
ICI (Feb. 2012) British Bankers' Ass'n.; Comm. on Capital Markets
Regulation; Thakor Study (stating that section 13 of the BHC Act
will likely result in higher bid-ask spreads by causing at least
some retrenchment of banks from market making, resulting in fewer
market makers and less competition).
    \547\ See, e.g., Wellington; Prof. Duffie; Standish Mellon; Lord
Abbett; IIF; SIFMA et al. (Prop. Trading) (Feb. 2012); Barclays;
Goldman (Prop. Trading); BDA (Feb. 2012); IHS; FTN; IAA; Wells Fargo
(Prop. Trading); T. Rowe Price; Columbia Mgmt.; SSgA (Feb. 2012);
Eaton Vance; British Bankers' Ass'n.; Comm. on Capital Markets
Regulation.
    \548\ See, e.g., Prof. Duffie (arguing that, for example,
``during the financial crisis of 2007-2009, the reduced market
making capacity of major dealer banks caused by their insufficient
capital levels resulted in dramatic downward distortions in
corporate bond prices''); IIF; Barclays; IAA; Vanguard; Wellington;
FTN.
    \549\ See, e.g., AllianceBernstein; Chamber (Dec. 2011); Members
of Congress (Dec. 2011); Wellington; Sen. Hagan; Prof. Duffie; IR&M
MetLife; Lord Abbett; Liberty Global; NYSE Euronext; SIFMA et al.
(Prop. Trading) (Feb. 2012); NCSHA; ASF (Feb. 2012) (stating that
``[f]ailure to permit the activities necessary for banking entities
to act in [a] market-making capacity [in asset-backed securities]
would have a dramatic adverse effect on the ability of securitizers
to access the asset-backed securities markets and thus to obtain the
debt financing necessary to ensure a vibrant U.S. economy''); Credit
Suisse (Seidel); JPMC; Morgan Stanley; Barclays; Goldman (Prop.
Trading); BoA; Citigroup (Feb. 2012); STANY; BlackRock; Chamber
(Feb. 2012); IHS; BDA (Feb. 2012); Fixed Income Forum/Credit
Roundtable; ACLI (Feb. 2012); Wells Fargo (Prop. Trading); Abbott
Labs et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012); T.
Rowe Price; FEI; AFMA; SSgA (Feb. 2012); PNC et al.; ICI (Feb.
2012); British Bankers' Ass'n.; Oliver Wyman (Dec. 2011); Oliver
Wyman (Feb. 2012); GE (Feb. 2012); Thakor Study (stating that when a
firm's cost of capital goes up, it invests less--resulting in lower
economic growth and lower employment--and citing supporting data
indicating that a 1 percent increase in the cost of capital would
lead to a $55 to $82.5 billion decline in aggregate annual capital
spending by U.S. nonfarm firms and job losses between 550,000 and
1.1 million per year in the nonfarm sector). One commenter further
noted that a higher cost of capital can lead a firm to make riskier,
short-term investments. See Thakor Study.
    \550\ See, e.g., Wellington; Standish Mellon; IR&M MetLife;
Lord Abbett; NYSE Euronext; CIEBA; Barclays; Goldman (Prop.
Trading); BoA; Citigroup (Feb. 2012); STANY; ICE; BlackRock; Fixed
Income Forum/Credit Roundtable; ACLI (Feb. 2012); IAA; Abbott Labs
et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012); T. Rowe
Price; Vanguard; Australian Bankers Ass'n. (Feb. 2012); FEI; Sen.
Carper et al.; Columbia Mgmt.; SSgA (Feb. 2012); ICI (Feb. 2012);
Comm. on Capital Markets Regulation; TMA Hong Kong; Sen. Casey; IHS;
Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012); Thakor Study.
    \551\ See, e.g., Barclays; FTN; Abbott Labs et al. (Feb. 14,
2012); Abbott Labs et al. (Feb. 21, 2012).
    \552\ See, e.g., AllianceBernstein (stating that, to the extent
the rule reduces liquidity provided by market makers, open end
mutual funds that are largely driven by the need to respond to both
redemptions and subscriptions will be immediately impacted in terms
of higher trading costs); Wellington (indicating that periods of
extreme market stress are likely to exacerbate costs and challenges,
which could force investors such as mutual funds and pension funds
to accept distressed prices to fund redemptions or pay current
benefits); Lord Abbett (stating that certain factors, such as
reduced bank capital to support market-making businesses and
economic uncertainty, have already reduced liquidity and caused
asset managers to have an increased preference for highly liquid
credits and expressing concern that, if section 13 of the BHC Act
further reduces liquidity, then: (i) Asset managers' increased
preference for highly liquid credit could lead to unhealthy
portfolio concentrations, and (ii) asset managers will maintain a
larger cash cushion in portfolios that may be subject to redemption,
which will likely result in investors getting poorer returns);
EFAMA; BlackRock (stating that investment decisions are heavily
dependent on a liquidity factor input, so as liquidity dissipates,
investment strategies become more limited and returns to investors
are diminished by wider spreads and higher transaction costs); CFA
Inst. (noting that a mutual fund that tries to liquidate holdings to
meet redemptions may have difficulty selling at acceptable prices,
thus impairing the fund's NAV for both redeeming investors and for
those that remain in the fund); Putnam; Fixed Income Forum/Credit
Roundtable; ACLI; T. Rowe Price; Vanguard; IAA; FEI; Sen. Carper et
al.; Columbia Mgmt.; ICI (Feb. 2012); Invesco; Union Asset; Standish
Mellon; Morgan Stanley; SIFMA (Asset Mgmt.) (Feb. 2012).
    \553\ See, e.g., CIEBA (stating that for smaller issuers in
particular, market makers need to have incentives to make markets,
and the proposal removes important incentives); ACLI (indicating
that lower liquidity will most likely result in higher costs for
issuers of debt and, for lesser known or lower quality issuers, this
cost may be significant and in some cases prohibitive because the
cost will vary depending on the credit quality of the issuer, the
amount of debt it has in the market, and the maturity of the
security); PNC et al. (expressing concern that a regional bank's
market-making activity for small and middle market customers is more
likely to be inappropriately characterized as impermissible
proprietary trading due to lower trading volume involving less
liquid securities); Morgan Stanley; Chamber (Feb. 2012); Abbott Labs
et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012); FEI; ICI
(Feb. 2012); TMA Hong Kong; Sen. Casey.
    \554\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; RBC;
NYSE Euronext; Credit Suisse (Seidel).
---------------------------------------------------------------------------

    A few commenters expressed the view that reduced liquidity would
not necessarily be a negative result.\555\ For example, two commenters
noted that liquidity is vulnerable to liquidity spirals, in which a
high level of market liquidity during one period feeds a sharp decline
in liquidity during the next period by initially driving asset prices
upward and supporting increased leverage. The commenters explained that
liquidity spirals lead to ``fire sales'' by market speculators when
events reveal that assets are overpriced and speculators must sell
their assets to reduce their leverage.\556\ According to another
commenter, banking entities' access to the safety net allows them to
distort market prices and, arguably, produce excess liquidity. The
commenter further represented that it would be preferable to allow the
discipline of the market to choose the pricing of securities and the
amount of liquidity.\557\ Some commenters cited an economic study
indicating that the U.S. financial system has become less efficient in
generating economic growth in recent years, despite increased trading
volumes.\558\
---------------------------------------------------------------------------

    \555\ See, e.g., Paul Volcker; AFR et al. (Feb. 2012); Public
Citizen; Prof. Richardson; Johnson & Prof. Stiglitz; Better Markets
(Feb. 2012); Prof. Johnson.
    \556\ See AFR et al. (Feb. 2012); Public Citizen. See also Paul
Volcker (stating that at some point, greater liquidity, or the
perception of greater liquidity, may encourage more speculative
trading).
    \557\ See Prof. Richardson.
    \558\ See, e.g., Johnson & Prof. Stiglitz (citing Thomas
Phillippon, Has the U.S. Finance Industry Become Less Efficient?,
NYU Working Paper, Nov. 2011); AFR et al. (Feb. 2012); Public
Citizen; Better Markets (Feb. 2012); Prof. Johnson.
---------------------------------------------------------------------------

    Some commenters stated that it is unlikely the proposed rule would
result in the negative market impacts identified above, such as reduced
market liquidity.\559\ For example, a few commenters stated that other
market participants, who are not subject to section 13 of the BHC Act,
may enter the market or increase their trading activities to make up
for any reduction in banking entities' market-making

activity or other trading activity.\560\ For instance, one of these
commenters suggested that the revenue and profits from market making
will be sufficient to attract capital and competition to that
activity.\561\ In addition, one commenter expressed the view that
prohibiting proprietary trading may support more liquid markets by
ensuring that banking entities focus on providing liquidity as market
makers, rather than taking liquidity from the market in the course of
``trading to beat'' institutional buyers like pension funds, university
endowments, and mutual funds.\562\ Another commenter stated that, while
section 13 of the BHC Act may temporarily reduce trading volume and
excessive liquidity at the peak of market bubbles, it should increase
the long-run stability of the financial system and render genuine
liquidity and credit availability more reliable over the long
term.\563\
---------------------------------------------------------------------------

    \559\ See, e.g., Sens. Merkley & Levin (Feb. 2012) (stating that
there is no convincing, independent evidence that the rule would
increase trading costs or reduce liquidity, and the best evidence
available suggests that the buy-side firms would greatly benefit
from the competitive pressures that transparency can bring); Better
Markets (Feb. 2012) (``Industry's claim that [section 13 of the BHC
Act] will `reduce market liquidity, capital formation, and credit
availability, and thereby hamper economic growth and job creation'
disregard the fact that the financial crisis did more damage to
those concerns than any rule or reform possibly could.''); Profs.
Stout & Hastings; Prof. Johnson; Occupy; Public Citizen; Profs.
Admati & Pfleiderer; Better Markets (June 2012); AFR et al. (Feb.
2012). One commenter stated that the proposed rule would improve
market liquidity, efficiency, and price transparency. See Alfred
Brock.
    \560\ See, e.g., Sens. Merkley & Levin (Feb. 2012); Prof.
Richardson; Better Markets (Feb. 2012); Profs. Stout & Hastings;
Prof. Johnson; Occupy; Public Citizen; Profs. Admati & Pfleiderer;
Better Markets (June 2012). Similarly, one commenter indicated that
non-banking entity market participants could fill the current role
of banking entities in the market if implementation of the rule is
phased in. See ACLI (Feb. 2012).
    \561\ See Better Markets (Feb. 2012).
    \562\ See Prof. Johnson.
    \563\ See AFR et al. (Feb. 2012).
---------------------------------------------------------------------------

    Other commenters, however, indicated that it is uncertain or
unlikely that non-banking entities will enter the market or increase
their trading activities, particularly in the short term.\564\ For
example, one commenter noted the investment that banking entities have
made in infrastructure for trading and compliance would take smaller or
new firms years and billions of dollars to replicate.\565\ Another
commenter questioned whether other market participants, such as hedge
funds, would be willing to dedicate capital to fully serving customer
needs, which is required to provide ongoing liquidity.\566\ One
commenter stated that even if non-banking entities move in to replace
lost trading activity from banking entities, the value of the current
interdealer network among market makers will be reduced due to the exit
of banking entities.\567\ Several commenters expressed the view that
migration of market making-related activities to firms outside the
banking system would be inconsistent with Congressional intent and
would have potentially adverse consequences for the safety and
soundness of the U.S. financial system.\568\
---------------------------------------------------------------------------

    \564\ See, e.g., Wellington; Prof. Duffie; Investure; IIF;
Liberty Global; SIFMA et al. (Prop. Trading) (Feb. 2012); Credit
Suisse (Seidel); JPMC; Morgan Stanley; Barclays; BoA; STANY; SIFMA
(Asset Mgmt.) (Feb. 2012); FTN; Western Asset Mgmt.; IAA; PUC Texas;
ICI (Feb. 2012); IIB/EBF; Invesco. In addition, some commenters
recognized that other market participants are likely to fill banking
entities' roles in the long term, but not in the short term. See,
e.g., ICFR; Comm. on Capital Markets Regulation; Oliver Wyman (Feb.
2012).
    \565\ See Oliver Wyman (Feb. 2012) (``Major bank-affiliated
market makers have large capital bases, balance sheets, technology
platforms, global operations, relationships with clients, sales
forces, risk infrastructure, and management processes that would
take smaller or new dealers years and billions of dollars to
replicate.'').
    \566\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \567\ See Thakor Study.
    \568\ See, e.g., Prof. Duffie; Oliver Wyman (Feb. 2012).
---------------------------------------------------------------------------

    Many commenters requested additional clarification on how the
proposed market-making exemption would apply to certain asset classes
and markets or to particular types of market making-related activities.
In particular, commenters requested greater clarity regarding the
permissibility of: (i) interdealer trading,\569\ including trading for
price discovery purposes or to test market depth; \570\ (ii) inventory
management; \571\ (iii) block positioning activity; \572\ (iv) acting
as an authorized participant or market maker in ETFs; \573\ (v)
arbitrage or other activities that promote price transparency and
liquidity; \574\ (vi) primary dealer activity; \575\ (vii) market
making in futures and options; \576\ (viii) market making in new or
bespoke products or customized hedging contracts; \577\ and (ix) inter-
affiliate transactions.\578\ As discussed in more detail in Part
IV.B.2.c., a number of commenters requested that the market-making
exemption apply to the restrictions on acquiring or retaining an
ownership interest in a covered fund.\579\ Some commenters stated that
no other activities should be considered permitted market making-
related activity under the rule.\580\ In addition, a few commenters
requested clarification that high-frequency trading would not qualify
for the market-making exemption.\581\
---------------------------------------------------------------------------

    \569\ See, e.g., MetLife; SIFMA et al. (Prop. Trading) (Feb.
2012); RBC; Credit Suisse (Seidel); JPMC; BoA; ACLI (Feb. 2012); AFR
et al. (Feb. 2012); ISDA (Feb. 2012); Goldman (Prop. Trading);
Oliver Wyman (Feb. 2012).
    \570\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Chamber
(Feb. 2012); Goldman (Prop. Trading).
    \571\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);
Credit Suisse (Seidel); Goldman (Prop. Trading); MFA; RBC.
    \572\ See infra Part IV.A.3.c.1.b.ii. (discussing commenters'
requests for greater clarity regarding the permissibility of block
positioning activity).
    \573\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);
Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); BoA; ICI
(Feb. 2012); ICI Global; Vanguard; SSgA (Feb. 2012).
    \574\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit
Suisse (Seidel); JPMC; Goldman (Prop. Trading); FTN; RBC; ISDA (Feb.
2012).
    \575\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC;
Goldman (Prop. Trading); Banco de M[eacute]xico; IIB/EBF.
    \576\ See CME Group (requesting clarification that the market-
making exemption permits a banking entity to engage in market making
in exchange-traded futures and options because the dealer
registration requirement in Sec.  ----.4(b)(2)(iv) of the proposed
rule did not refer to such instruments and stating that lack of an
explicit exemption would reduce market-making activities in these
instruments, which would decrease liquidity). But See Johnson &
Prof. Stiglitz (stating that the Agencies should pay special
attention to options trading and other derivatives because they are
highly volatile assets that are difficult if not impossible to
effectively hedge, except through a completely matched position, and
suggesting that options and similar derivatives may need to be
required to be sold only as riskless principal under Sec.  --
--.6(b)(1)(ii) of the proposed rule or significantly limited through
capital charges); Sens. Merkley & Levin (Feb. 2012) (stating that
asset classes that are particularly hard to hedge, such as options,
should be given special attention under the hedging exemption).
    \577\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);
Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); SIFMA (Asset
Mgmt.) (Feb. 2012). Other commenters, however, stated that banking
entities should be limited in their ability to rely on the market-
making exemption to conduct transactions in bespoke or customized
derivatives. See, e.g., AFR et al. (Feb. 2012); Public Citizen.
    \578\ See, e.g., Japanese Bankers Ass'n. (stating that
transactions with affiliates and subsidiaries and related to hedging
activities are a type of market making-related activity or risk-
mitigating hedging activity that should be exempted by the rule);
SIFMA et al. (Prop. Trading) (Feb. 2012). According to one of these
commenters, inter-affiliate transactions should be viewed as part of
a coordinated activity for purposes of determining whether a banking
entity qualifies for an exemption. This commenter stated that, for
example, if a market maker shifts positions held in inventory to an
affiliate that is better able to manage the risk of such positions,
both the market maker and its affiliate would be engaged in
permitted market making-related activity. This commenter further
represented that fitting the inter-affiliate swap into the exemption
may be difficult (e.g., one of the affiliates entering into the swap
may not be holding itself out as a willing counterparty). See SIFMA
et al. (Prop. Trading) (Feb. 2012).
    \579\ See, e.g., Cleary Gottlieb; JPMC; BoA; Credit Suisse
(Williams).
    \580\ See, e.g., Occupy; Alfred Brock.
    \581\ See, e.g., Occupy; AFR et al. (Feb. 2012); Public Citizen;
Johnson & Prof. Stiglitz; Sens. Merkley & Levin (Feb. 2012); John
Reed.
---------------------------------------------------------------------------

3. Final Market-Making Exemption
    After carefully considering comment letters, the Agencies are
adopting certain refinements to the proposed market-making exemption.
The Agencies are adopting a market-making exemption that is consistent
with the statutory exemption for this activity and designed to permit
banking entities to continue providing intermediation and liquidity
services. The Agencies note that, while all market-making activity
should ultimately be related to the intermediation of trading, whether
directly to individual customers through bilateral transactions or more
broadly to

a given marketplace, certain characteristics of a market-making
business may differ among markets and asset classes.\582\ The final
rule is intended to account for these differences to allow banking
entities to continue to engage in market making-related activities by
providing customer intermediation and liquidity services across markets
and asset classes, if such activities do not violate the statutory
limitations on permitted activities (e.g., by involving or resulting in
a material conflict of interest with a client, customer, or
counterparty) and are conducted in conformance with the exemption.
---------------------------------------------------------------------------

    \582\ Consistent with the FSOC study and the proposal, the final
rule recognizes that the precise nature of a market maker's
activities often varies depending on the liquidity, trade size,
market infrastructure, trading volumes and frequency, and geographic
location of the market for any particular type of financial
instrument. See Joint Proposal, 76 FR 68,870; CFTC Proposal, 77 FR
8356; FSOC study (stating that ``characteristics of permitted
activities in one market or asset class may not be the same in
another market (e.g., permitted activities in a liquid equity
securities market may vary significantly from an illiquid over-the-
counter derivatives market)'').
---------------------------------------------------------------------------

    At the same time, the final rule requires development and
implementation of trading, risk and inventory limits, risk management
strategies, analyses of how the specific market making-related
activities are designed not to exceed the reasonably expected near term
demands of customers, compensation standards, and monitoring and review
requirements that are consistent with market-making activities.\583\
These requirements are designed to distinguish exempt market making-
related activities from impermissible proprietary trading. In addition,
these requirements are designed to ensure that a banking entity is
aware of, monitors, and limits the risks of its exempt activities
consistent with the prudent conduct of market making-related
activities.
---------------------------------------------------------------------------

    \583\ Certain of these requirements, like the requirements to
have risk and inventory limits, risk management strategies, and
monitoring and review requirements were included in the enhanced
compliance program requirement in proposed Appendix C, but were not
separately included in the proposed market-making exemption. Like
the statute, the proposed rule would have required that market
making-related activities be designed not to exceed the reasonably
expected near term demand of clients, customers, or counterparties.
The Agencies are adding an explicit requirement in the final rule
that a trading desk conduct analyses of customer demand for purposes
of complying with this statutory requirement.
---------------------------------------------------------------------------

    As described in detail below, the final market-making exemption
consists of the following elements:
     A framework that recognizes the differences in market
making-related activities across markets and asset classes by
establishing criteria that can be applied based on the liquidity,
maturity, and depth of the market for the particular type of financial
instrument.
     A general focus on analyzing the overall ``financial
exposure'' and ``market-maker inventory'' held by any given trading
desk rather than a transaction-by-transaction analysis. The ``financial
exposure'' reflects the aggregate risks of the financial instruments,
and any associated loans, commodities, or foreign exchange or currency,
held by a banking entity or its affiliate and managed by a particular
trading desk as part of its market making-related activities. The
``market-maker inventory'' means all of the positions, in the financial
instruments for which the trading desk stands ready to make a market
that are managed by the trading desk, including the trading desk's open
positions or exposures arising from open transactions.\584\
---------------------------------------------------------------------------

    \584\ See infra Part IV.A.3.c.1.c.ii. See also final rule
Sec. Sec.  ----.4(b)(4), (5).
---------------------------------------------------------------------------

     A definition of the term ``trading desk'' that focuses on
the operational functionality of the desk rather than its legal status,
and requirements that apply at the trading desk level of organization
within a single banking entity or across two or more affiliates.\585\
---------------------------------------------------------------------------

    \585\ See infra Part IV.A.3.c.1.c.i. The term ``trading desk''
is defined as ``the smallest discrete unit of organization of a
banking entity that buys or sells financial instruments for the
trading account of the banking entity or an affiliate thereof.''
Final rule Sec.  ----.3(e)(13).
---------------------------------------------------------------------------

     Five requirements for determining whether a banking entity
is engaged in permitted market making-related activities. Many of these
criteria have similarities to the factors included in the proposed
rule, but with important modifications in response to comments. These
standards require that:
    [cir] The trading desk that establishes and manages a financial
exposure routinely stands ready to purchase and sell one or more types
of financial instruments related to its financial exposure and is
willing and available to quote, buy and sell, or otherwise enter into
long and short positions in those types of financial instruments for
its own account, in commercially reasonable amounts and throughout
market cycles, on a basis appropriate for the liquidity, maturity, and
depth of the market for the relevant types of financial instruments;
\586\
---------------------------------------------------------------------------

    \586\ See final rule Sec.  ----.4(b)(2)(i); infra Part
IV.A.3.c.1.c.iii.
---------------------------------------------------------------------------

    [cir] The amount, types, and risks of the financial instruments in
the trading desk's market-maker inventory are designed not to exceed,
on an ongoing basis, the reasonably expected near term demands of
clients, customers, or counterparties, as required by the statute and
based on certain factors and analysis; \587\
---------------------------------------------------------------------------

    \587\ See final rule Sec.  ----.4(b)(2)(ii); infra Part
IV.A.3.c.2.c. In addition, the Agencies are adopting a definition of
the terms ``client,'' ``customer,'' and ``counterparty'' in Sec.  --
--.4(b)(3) of the final rule.
---------------------------------------------------------------------------

    [cir] The banking entity has established and implements, maintains,
and enforces an internal compliance program that is reasonably designed
to ensure its compliance with the market-making exemption, including
reasonably designed written policies and procedures, internal controls,
analysis, and independent testing identifying and addressing:
    [ssquf] The financial instruments each trading desk stands ready to
purchase and sell in accordance with Sec.  ----.4(b)(2)(i) of the final
rule;
    [ssquf] The actions the trading desk will take to demonstrably
reduce or otherwise significantly mitigate promptly the risks of its
financial exposure consistent with its established limits; the
products, instruments, and exposures each trading desk may use for risk
management purposes; the techniques and strategies each trading desk
may use to manage the risks of its market making-related activities and
inventory; and the process, strategies, and personnel responsible for
ensuring that the actions taken by the trading desk to mitigate these
risks are and continue to be effective; \588\
---------------------------------------------------------------------------

    \588\ Routine market making-related risk management activity by
a trading desk is permitted under the market-making exemption and,
provided the standards of the exemption are met, is not required to
separately meet the requirements of the hedging exemption. The
circumstances under which risk management activity relating to the
trading desk's financial exposure is permitted under the market-
making exemption or must separately comply with the hedging
exemption are discussed in more detail in Parts IV.A.3.c.1.c.ii. and
IV.A.3.c.4., infra.
---------------------------------------------------------------------------

    [ssquf] Limits for each trading desk, based on the nature and
amount of the trading desk's market making-related activities,
including factors used to determine the reasonably expected near term
demands of clients, customers, or counterparties, on: the amount,
types, and risks of its market-maker inventory; the amount, types, and
risks of the products, instruments, and exposures the trading desk uses
for risk management purposes; the level of exposures to relevant risk
factors arising from its financial exposure; and the period of time a
financial instrument may be held;
    [ssquf] Internal controls and ongoing monitoring and analysis of
each trading desk's compliance with its limits; and
    [ssquf] Authorization procedures, including escalation procedures
that

require review and approval of any trade that would exceed a trading
desk's limit(s), demonstrable analysis that the basis for any temporary
or permanent increase to a trading desk's limit(s) is consistent with
the requirements of the market-making exemption, and independent review
of such demonstrable analysis and approval; \589\
---------------------------------------------------------------------------

    \589\ See final rule Sec.  ----.4(b)(2)(iii); infra Part
IV.A.3.c.3.
---------------------------------------------------------------------------

    [cir] To the extent that any limit identified above is exceeded,
the trading desk takes action to bring the trading desk into compliance
with the limits as promptly as possible after the limit is exceeded;
\590\
---------------------------------------------------------------------------

    \590\ See final rule Sec.  ----.4(b)(2)(iv).
---------------------------------------------------------------------------

    [cir] The compensation arrangements of persons performing market
making-related activities are designed not to reward or incentivize
prohibited proprietary trading; \591\ and
---------------------------------------------------------------------------

    \591\ See final rule Sec.  ----.4(b)(2)(v); infra Part
IV.A.3.c.5.
---------------------------------------------------------------------------

    [cir] The banking entity is licensed or registered to engage in
market making-related activities in accordance with applicable
law.\592\
---------------------------------------------------------------------------

    \592\ See final rule Sec.  ----.4(b)(2)(vi); infra Part
IV.A.3.c.6. As discussed further below, this provision pertains to
legal registration or licensing requirements that may apply to an
entity engaged in market making-related activities, depending on the
facts and circumstances. This provision would not require a banking
entity to comply with registration requirements that are not
required by law, such as discretionary registration with a national
securities exchange as a market maker on that exchange.
---------------------------------------------------------------------------

     The use of quantitative measurements to highlight
activities that warrant further review for compliance with the
exemption.\593\ As discussed further in Part IV.C.3., the Agencies have
reduced some of the compliance burdens by adopting a more tailored
subset of metrics than was proposed to better focus on those metrics
that the Agencies believe are most germane to the evaluation of the
activities that firms conduct under the market-making exemption.
---------------------------------------------------------------------------

    \593\ See infra Part IV.C.3.
---------------------------------------------------------------------------

    In refining the proposed approach to implementing the statute's
market-making exemption, the Agencies closely considered the various
alternative approaches suggested by commenters.\594\ However, like the
proposed approach, the final market-making exemption continues to
adhere to the statutory mandate that provides for an exemption to the
prohibition on proprietary trading for market making-related
activities. Therefore, the final rule focuses on providing a framework
for assessing whether trading activities are consistent with market
making. The Agencies believe this approach is consistent with the
statute \595\ and strikes an appropriate balance between commenters'
desire for both clarity and flexibility. For example, while a bright-
line or safe harbor based approach would generally provide a high
degree of certainty about whether an activity qualifies for the market-
making exemption, it would also provide less flexibility to recognize
the differences in market-making activities across markets and asset
classes.\596\ In addition, any bright-line approach would be more
likely to be subject to gaming and avoidance as new products and types
of trading activities are developed than other approaches to
implementing the market-making exemption.\597\ Although a purely
guidance-based approach would provide greater flexibility, it would
also provide less clarity, which could make it difficult for trading
personnel, internal compliance personnel, and Agency supervisors and
examiners to determine whether an activity complies with the rule and
would lead to an increased risk of evasion of the statutory
requirements.\598\
---------------------------------------------------------------------------

    \594\ See supra Part IV.A.3.b.2.
    \595\ Certain approaches suggested by commenters, such as
relying solely on capital requirements, requiring ring fencing,
permitting all swap dealing activity, or focusing solely on how
traders are compensated do not appear to be consistent with the
statutory language because they do not appear to limit market
making-related activity to that which is designed not to exceed the
reasonably expected near term demands of clients, customers, or
counterparties, as required by the statute. See Prof. Duffie; STANY;
ICE; Shadow Fin. Regulatory Comm.; ISDA (Feb. 2012); ISDA (Apr.
2012); G2 FinTech.
    \596\ While an approach establishing a number of safe harbors
that are each tailored to a specific asset class would address the
need to recognize differences across asset classes, such an approach
may also increase the complexity of the final rule. Further,
commenters did not provide sufficient information to determine the
appropriate parameters of a safe harbor-based approach.
    \597\ As noted above, a number of commenters suggested the
Agencies adopt a bright-line rule, provide a safe harbor for certain
types of activities, or establish a presumption of compliance based
on certain factors. See, e.g., Sens. Merkley & Levin (Feb. 2012);
John Reed; Prof. Richardson; Johnson & Prof. Stiglitz; Capital
Group; Invesco; BDA (Oct. 2012); Flynn & Fusselman; Prof. Colesanti
et al.; SIFMA et al. (Prop. Trading) (Feb. 2012); IIF; NYSE
Euronext; Credit Suisse (Seidel); JPMC; Barclays; BoA; Wells Fargo
(Prop. Trading); PNC et al.; Oliver Wyman (Feb. 2012). Many of these
commenters expressed general concern that the proposed market-making
exemption may create uncertainty for individual traders engaged in
market making-related activity and suggested that their proposed
approach would alleviate such concern. The Agencies believe that the
enhanced focus on risk and inventory limits for each trading desk
(which must be tied to the near term customer demand requirement)
and the clarification that the final market-making exemption does
not require a trade-by-trade analysis should address concerns about
individual traders having to assess whether they are complying with
the market-making exemption on a trade-by-trade basis.
    \598\ Several commenters suggested a guidance-based approach,
rather than requirements in the final rule. See, e.g., SIFMA et al.
(Prop. Trading) (Feb. 2012) (suggesting that this guidance could
then be incorporated in banking entities' policies and procedures
for purposes of complying with the rule, in addition to the
establishment of risk limits, controls, and metrics); JPMC; BoA; PUC
Texas; SSgA (Feb. 2012); PNC et al.; Wells Fargo (Prop. Trading).
---------------------------------------------------------------------------

    Some commenters suggested an approach to implementing the market-
making exemption that would focus on metrics or other objective
factors.\599\ As discussed below, a number of commenters expressed
support for using the metrics as a tool to monitor trading activity and
not to determine compliance with the rule.\600\ While the Agencies
agree that quantitative measurements are useful for purposes of
monitoring a trading desk's activities and are requiring certain
banking entities to calculate, record, and report quantitative
measurements to the Agencies in the final rule, the Agencies do not
believe that quantitative measurements should be used as a dispositive
tool for determining compliance with the market-making exemption.\601\
---------------------------------------------------------------------------

    \599\ See, e.g., Goldman (Prop. Trading); Morgan Stanley;
Barclays; Wellington; CalPERS; BlackRock; SSgA (Feb. 2012); Invesco.
    \600\ See infra Part IV.C.3. (discussing the final rule's
metrics requirement). See SIFMA et al. (Prop. Trading) (Feb. 2012);
Wells Fargo (Prop. Trading); RBC; ICI (Feb. 2012); Occupy (stating
that there are serious limits to the capabilities of the metrics and
the potential for abuse and manipulation of the input data is
significant); Alfred Brock.
    \601\ See infra Part IV.C.3. (discussing the final metrics
requirement).
---------------------------------------------------------------------------

    In response to two commenters' request that the final rule focus on
a banking entity's risk management structures or risk limits and not on
attempting to define market-making activities,\602\ the Agencies do not
believe that management of risk, on its own, is sufficient to
differentiate permitted market making-related activities from
impermissible proprietary trading. For example, the existence of a risk
management framework or risk limits, while important, would not ensure
that a trading desk is acting as a market maker by engaging in
customer-facing activity and providing intermediation and liquidity
services.\603\ The Agencies also decline to take an approach to
implementing the market-making exemption that would require the
development of individualized plans for each banking entity in
coordination with the Agencies, as suggested by a few

commenters.\604\ The Agencies believe it is useful to establish a
consistent framework that will apply to all banking entities to reduce
the potential for unintended competitive impacts that could arise if
each banking entity is subject to an individualized plan that is
tailored to its specific organizational structure and trading
activities and strategies.
---------------------------------------------------------------------------

    \602\ See, e.g., Japanese Bankers Ass'n.; Citigroup (Feb. 2012).
    \603\ However, as discussed below, the Agencies believe risk
limits can be a useful tool when they must account for the nature
and amount of a particular trading desk's market making-related
activities, including the reasonably expected near term demands of
clients, customers, or counterparties.
    \604\ See MetLife; Fixed Income Forum/Credit Roundtable; ACLI
(Feb. 2012).
---------------------------------------------------------------------------

    Although the Agencies are not in the final rule modifying the basic
structure of the proposed market-making exemption, certain general
items suggested by commenters, such as enhanced compliance program
elements and risk limits, have been incorporated in the final rule text
for the market-making exemption, instead of a separate appendix.\605\
Moreover, as described below, the final market-making exemption
includes specific substantive changes in response to a wide variety of
commenter concerns.
---------------------------------------------------------------------------

    \605\ The Agencies are not, however, adding certain additional
requirements suggested by commenters, such as a new customer-facing
criterion, margin requirements, or additional provisions regarding
material conflicts of interest or high-risk assets or trading
strategies. See, e.g., Morgan Stanley; Stephen Roach; WR Hambrecht;
Sens. Merkley & Levin (Feb. 2012). The Agencies believe that the
final rule includes sufficient requirements to ensure that a trading
desk relying on the market-making exemption is engaged in customer-
facing activity (for example, the final rule requires the trading
desk to stand ready to buy and sell a type of financial instrument
as market maker and that the trading desk's market-maker inventory
is designed not to exceed the reasonably expected near term demands
of clients, customers, or counterparties). The Agencies decline to
include margin requirements in the final exemption because banking
entities are currently subject to a number of different margin
requirements, including those applicable to, among others: SEC-
registered broker-dealers; CFTC-registered swap dealers; SEC-
registered security-based swap dealers: And foreign dealer entities.
Further, the Agencies are not providing new requirements regarding
material conflicts of interest and high-risk assets and trading
strategies in the market-making exemption because the Agencies
believe these issues are adequately addressed in Sec.  ----.7 of the
final rule. The limitations in Sec.  ----.7 will apply to market
making-related activities and all other exempted activities.
---------------------------------------------------------------------------

    The Agencies understand that the economics of market making--and
financial intermediation in general--require a market maker to be
active in markets. In determining the appropriate scope of the market-
making exemption, the Agencies have been mindful of commenters' views
on market making and liquidity. Several commenters stated that the
proposed rule would impact a banking entity's ability to engage in
market making-related activity, with corresponding reductions in market
liquidity.\606\ However, commenters disagreed about whether reduced
liquidity would be beneficial or detrimental to the market, or if any
such reductions would even materialize.\607\ Many commenters stated
that reduced liquidity could lead to other negative market impacts,
such as wider spreads, higher transaction costs, greater market
volatility, diminished price discovery, and increased cost of capital.
---------------------------------------------------------------------------

    \606\ See supra note 545 and accompanying text. The Agencies
acknowledge that reduced liquidity can be costly. One commenter
provided estimated impacts on asset valuation, borrowing costs, and
transaction costs in the corporate bond market based on certain
hypothetical scenarios of reduced market liquidity. This commenter
noted that its hypothetical liquidity shifts of 5, 10, and 15
percentile points were ``necessarily arbitrary'' but judged ``to be
realistic potential outcomes of the proposed rule.'' Oliver Wyman
(Feb. 2012). Because the Agencies have made significant
modifications to the proposed rule in response to comments, the
Agencies believe this commenter's concerns about the market impacts
of the proposed rule have been substantially addressed.
    \607\ As noted above, a few commenters stated that reduced
liquidity may provide certain benefits. See, e.g., Paul Volcker; AFR
et al. (Feb. 2012); Public Citizen; Prof. Richardson; Johnson &
Prof. Stiglitz; Better Markets (Feb. 2012); Prof. Johnson. However,
a number of commenters stated that reduced liquidity would have
negative market impacts. See supra note 545 and accompanying text.
---------------------------------------------------------------------------

    The Agencies understand that market makers play an important role
in providing and maintaining liquidity throughout market cycles and
that restricting market-making activity may result in reduced
liquidity, with corresponding negative market impacts. For instance,
absent a market maker who stands ready to buy and sell, investors may
have to make large price concessions or otherwise expend resources
searching for counterparties. By stepping in to intermediate trades and
provide liquidity, market makers thus add value to the financial system
by, for example, absorbing supply and demand imbalances. This often
means taking on financial exposures, in a principal capacity, to
satisfy reasonably expected near term customer demand, as well as to
manage the risks associated with meeting such demand.
    The Agencies recognize that, as noted by commenters, liquidity can
be associated with narrower spreads, lower transaction costs, reduced
volatility, greater price discovery, and lower costs of capital.\608\
The Agencies agree with these commenters that liquidity provides
important benefits to the financial system, as more liquid markets are
characterized by competitive market makers, narrow bid-ask spreads, and
frequent trading, and that a narrowly tailored market-making exemption
could negatively impact the market by, as described above, forcing
investors to make price concessions or unnecessarily expend resources
searching for counterparties.\609\ For example, while bid-ask spreads
compensate market makers for providing liquidity when asset values are
uncertain, under competitive forces, dealers compete with respect to
spreads, thus lowering their profit margins on a per trade basis and
benefitting investors.\610\ Volatility is driven by both uncertainty
about fundamental value and the liquidity needs of investors. When
markets are illiquid, participants may have to make large price
concessions to find a counterparty willing to trade, increasing the
importance of the liquidity channel for addressing volatility. If
liquidity-based volatility is not diversifiable, investors will require
a risk premium for holding liquidity risk, increasing the cost of
capital.\611\ Commenters additionally suggested that the effects of
diminished liquidity could be concentrated in securities markets for
small or midsize companies or for lesser-known issuers, where trading
is already infrequent.\612\ Volume in these

markets can be low, increasing the inventory risk of market makers. The
Agencies recognize that, if the final rule creates disincentives for
banking entities to provide liquidity, these low volume markets may be
impacted first.
---------------------------------------------------------------------------

    \608\ See supra Part IV.A.3.b.2.b.
    \609\ See supra Part IV.A.3.b.2.b. As discussed above, a few
other commenters suggested that to the extent liquidity is
vulnerable to destabilizing liquidity spirals, any reduced liquidity
stemming from section 13 of the BHC Act and its implementing rules
would not necessarily be a negative result. See AFR et al. (Feb.
2012); Public Citizen. See also Paul Volcker. These commenters also
suggested that the Agencies adopt stricter conditions in the market-
making exemption, as discussed throughout this Part IV.A.3. However,
liquidity--essentially, the ease with which assets can be converted
into cash--is not destabilizing in and of itself. Rather, liquidity
spirals are a function of how firms are funded. During market
downturns, when margin requirements tend to increase, firms that
fund their operations with leverage face higher costs of providing
liquidity; firms that run up against their maximum leverage ratios
may be forced to retreat from market making, contributing to the
liquidity spiral. Viewed in this light, it is institutional features
of financial markets--in particular, leverage--rather than liquidity
itself that contributes to liquidity spirals.
    \610\ Wider spreads can be costly for investors. For example,
one commenter estimated that a 10 basis point increase in spreads in
the corporate bond market would cost investors $29 billion per year.
See Wellington. Wider spreads can also be particularly costly for
open-end mutual funds, which must trade in and out of the fund's
portfolio holdings on a daily basis in order to satisfy redemptions
and subscriptions. See Wellington; AllianceBernstein.
    \611\ A higher cost of capital increases financing costs and
translates into reduced capital investment. While one commenter
estimated that a one percent increase in the cost of capital would
lead to a $55 to $82.5 billion decline in capital investments by
U.S. nonfarm firms, the Agencies cannot independently verify these
potential costs. Further, this commenter did not indicate what
aspect of the proposed rule could cause a one percent increase in
the cost of capital. See Thakor Study. In any event, the Agencies
have made significant changes to the proposed approach to
implementing the market-making exemption that should help address
this commenter's concern.
    \612\ See, e.g., CIEBA; ACLI; PNC et al.; Morgan Stanley;
Chamber (Feb. 2012); Abbott Labs et al. (Feb. 14, 2012); FEI; ICI
(Feb. 2012); TMA Hong Kong; Sen. Casey.
---------------------------------------------------------------------------

    As discussed above, the Agencies received several comments
suggesting that the negative consequences associated with reduced
liquidity would be unlikely to materialize under the proposed rule. For
example, a few commenters stated that non-bank financial
intermediaries, who are not subject to section 13 of the BHC Act, may
increase their market-making activities in response to any reduction in
market making by banking entities, a topic the Agencies discuss in more
detail below.\613\ In addition, some commenters suggested that the
restrictions on proprietary trading would support liquid markets by
encouraging banking entities to focus on financial intermediation
activities that supply liquidity, rather than proprietary trades that
demand liquidity, such as speculative trades or trades that front-run
institutional investors.\614\ The statute prohibits proprietary trading
activity that is not exempted. As such, the termination of nonexempt
proprietary trading activities of banking entities may lead to some
general reductions in liquidity of certain asset classes. Although the
Agencies cannot say with any certainty, there is good reason to believe
that to a significant extent the liquidity reductions of this type may
be temporary since the statute does not restrict proprietary trading
activities of other market participants. Thus, over time, non-banking
entities may provide much of the liquidity that is lost by restrictions
on banking entities' trading activities. If so, eventually, the
detrimental effects of increased trading costs, higher costs of
capital, and greater market volatility should be mitigated.
---------------------------------------------------------------------------

    \613\ See, e.g., Sens. Merkley & Levin (Feb. 2012); Prof.
Richardson; Better Markets (Feb. 2012); Profs. Stout & Hastings;
Prof. Johnson; Occupy; Public Citizen; Profs. Admati & Pfleiderer;
Better Markets (June 2012).
    \614\ See, e.g., Prof. Johnson.
---------------------------------------------------------------------------

    Based on the many detailed comments provided, the Agencies have
made substantive refinements to the market-making exemption that the
Agencies believe will reduce the likelihood that the rule, as
implemented, will negatively impact the ability of banking entities to
engage in the types of market making-related activities permitted under
the statute and, therefore, will continue to promote the benefits to
investors and other market participants described above, including
greater market liquidity, narrower bid-ask spreads, reduced price
concessions and price impact, lower volatility, and reduced
counterparty search costs, thus reducing the cost of capital. For
instance, the final market-making exemption does not require a trade-
by-trade analysis, which was a significant source of concern from
commenters who represented, among other things, that a trade-by-trade
analysis could have a chilling effect on individual traders'
willingness to engage in market-making activities.\615\ Rather, the
final rule has been crafted around the overall market making-related
activities of individual trading desks, with various requirements that
these activities be demonstrably related to satisfying reasonably
expected near term customer demands and other market-making activities.
The Agencies believe that applying certain requirements to the
aggregate risk exposure of a trading desk, along with the requirement
to establish risk and inventory limits to routinize a trading desk's
compliance with the near term customer demand requirement, will reduce
negative potential impacts on individual traders' decision-making
process in the normal course of market making.\616\ In addition, in
response to a large number of comments expressing concern that the
proposed market-making exemption would restrict or prohibit market
making-related activities in less liquid markets, the Agencies are
clarifying that the application of certain requirements in the final
rule, such as the frequency of required quoting and the near term
demand requirement, will account for the liquidity, maturity, and depth
of the market for a given type of financial instrument. Thus, banking
entities will be able to continue to engage in market making-related
activities across markets and asset classes.
---------------------------------------------------------------------------

    \615\ See supra note 517 (discussing commenters' concerns
regarding a trade-by-trade analysis).
    \616\ For example, by clarifying that individual trades will not
be viewed in isolation and requiring strong compliance procedures,
this approach will generally allow an individual trader to operate
within the compliance framework established for his or her trading
desk without having to assess whether each individual transaction
complies with all requirements of the market-making exemption.
---------------------------------------------------------------------------

    At the same time, the Agencies recognize that an overly broad
market-making exemption may allow banking entities to mask speculative
positions as liquidity provision or related hedges. The Agencies
believe the requirements included in the final rule are necessary to
prevent such evasion of the market-making exemption, ensure compliance
with the statute, and facilitate internal banking entity and external
Agency reviews of compliance with the final rule. Nevertheless, the
Agencies acknowledge that these additional costs may have an impact on
banking entities' willingness to engage in market making-related
activities. Banking entities will incur certain compliance costs in
connection with their market making-related activities under the final
rule. For example, banking entities may not currently limit their
trading desks' market-maker inventory to that which is designed not to
exceed reasonably expected near term customer demand, as required by
the statute.
    As discussed above, commenters presented diverging views on whether
non-banking entities are likely to enter the market or increase their
market-making activities if the final rule should cause banking
entities to reduce their market-making activities.\617\ The Agencies
note that prior to the Gramm-Leach-Bliley Act of 1999, market-making
services were more commonly provided by non-bank-affiliated broker-
dealers than by banking entities. As discussed above, by intermediating
and facilitating trading, market makers provide value to the markets
and profit from providing liquidity. Should banking entities retreat
from making markets, the profit opportunities available from providing
liquidity will provide an incentive for non-bank-affiliated broker-
dealers to enter the market and intermediate trades. The Agencies are
unable to assess the likely effect with any certainty, but the Agencies
recognize that a market-making operation requires certain
infrastructure and capital, which will impact the ability of non-
banking entities to enter the market-making business or to increase
their presence. Therefore, should banking entities retreat from making
markets, there could be a transition period with reduced liquidity as
non-banking entities build up the needed infrastructure and obtain
capital. However, because the Agencies have substantially modified this
exemption in response to comments to ensure that

market making related to near-term customer demand is permitted as
contemplated by the statute, the Agencies do not believe the final rule
should significantly impact currently-available market-making
services.\618\
---------------------------------------------------------------------------

    \617\ See supra notes 560 and 564 and accompanying text
(discussing comments on the issue of whether non-banking entities
are likely to enter the market or increase their trading activities
in response to reduced trading activity by banking entities). For
example, one commenter stated that broker-dealers that are not
affiliated with a bank would have reduced access to lender-of-last
resort liquidity from the central bank, which could limit their
ability to make markets during times of market stress or when
capital buffers are small. See Prof. Duffie. However, another
commenter noted that the presence and evolution of market making
after the enactment of the Glass-Steagall Act mutes this particular
concern. See Prof. Richardson.
    \618\ Certain non-banking entities, such as some SEC-registered
broker-dealers that are not banking entities subject to the final
rule, currently engage in market-making activities and, thus, should
have the needed infrastructure and may attract additional capital.
If the final rule has a marginal impact on banking entities'
willingness to engage in market making-related activities, these
non-banking entities should be able to respond by increasing their
market making-related activities. The Agencies recognize, however,
that firms that do not have existing infrastructure or sufficient
capital are unlikely to be able to act as market makers shortly
after the final rule is implemented. Nevertheless, because some non-
bank-affiliated broker-dealers currently operate market-making
desks, and because it was the dominant model prior to the Gramm-
Leach-Bliley Act, the Agencies believe that non-bank-affiliated
financial intermediaries will be able to provide market-making
services longer term.
---------------------------------------------------------------------------

c. Detailed Explanation of the Market-Making Exemption
1. Requirement To Routinely Stand Ready to Purchase and Sell
a. Proposed Requirement To Hold Self Out
    Section ----.4(b)(2)(ii) of the proposed rule would have required
the trading desk or other organizational unit that conducts the
purchase or sale in reliance on the market-making exemption to hold
itself out as being willing to buy and sell, including through entering
into long and short positions in, the financial instrument for its own
account on a regular or continuous basis.\619\ The proposal stated that
a banking entity could rely on the proposed exemption only for the type
of financial instrument that the entity actually made a market in.\620\
---------------------------------------------------------------------------

    \619\ See proposed rule Sec.  ----.4(b)(2)(ii).
    \620\ See Joint Proposal, 76 FR 68,870 (``Notably, this
criterion requires that a banking entity relying on the exemption
with respect to a particular transaction must actually make a market
in the [financial instrument] involved; simply because a banking
entity makes a market in one type of [financial instrument] does not
permit it to rely on the market-making exemption for another type of
[financial instrument].''); CFTC Proposal, 77 FR 8355-8356.
---------------------------------------------------------------------------

    The proposal recognized that the precise nature of a market maker's
activities often varies depending on the liquidity, trade size, market
infrastructure, trading volumes and frequency, and geographic location
of the market for any particular financial instrument.\621\ To account
for these variations, the Agencies proposed indicia for assessing
compliance with this requirement that differed between relatively
liquid markets and less liquid markets. Further, the Agencies
recognized that the proposed indicia could not be applied at all times
and under all circumstances because some may be inapplicable to the
specific asset class or market in which the market making-related
activity is conducted.
---------------------------------------------------------------------------

    \621\ See Joint Proposal, 76 FR 68,870; CFTC Proposal, 77 FR
8356.
---------------------------------------------------------------------------

    In particular, the proposal stated that a trading desk or other
organizational unit's market making-related activities in relatively
liquid markets, such as equity securities or other exchange-traded
instruments, should generally include: (i) Making continuous, two-sided
quotes and holding oneself out as willing to buy and sell on a
continuous basis; (ii) a pattern of trading that includes both
purchases and sales in roughly comparable amounts to provide liquidity;
(iii) making continuous quotations that are at or near the market on
both sides; and (iv) providing widely accessible and broadly
disseminated quotes.\622\ With respect to market making in less liquid
markets, the proposal noted that the appropriate indicia of market
making-related activities will vary, but should generally include: (i)
holding oneself out as willing and available to provide liquidity by
providing quotes on a regular (but not necessarily continuous) basis;
\623\ (ii) with respect to securities, regularly purchasing securities
from, or selling securities to, clients, customers, or counterparties
in the secondary market; and (iii) transaction volumes and risk
proportionate to historical customer liquidity and investments
needs.\624\
---------------------------------------------------------------------------

    \622\ See Joint Proposal, 76 FR 68,870-68,871; CFTC Proposal, 77
FR 8356. These proposed factors are generally consistent with the
indicia used by the SEC to assess whether a broker-dealer is engaged
in bona fide market making for purposes of Regulation SHO under the
Exchange Act. See Joint Proposal, 76 FR 68,871 n.148; CFTC Proposal,
77 FR 8356 n.155.
    \623\ The Agencies noted that, with respect to this factor, the
frequency of regular quotations will vary, as moderately illiquid
markets may involve quotations on a daily or more frequent basis,
while highly illiquid markets may trade only by appointment. See
Joint Proposal, 76 FR 68,871 n.149; CFTC Proposal, 77 FR 8356 n.156.
    \624\ See Joint Proposal, 76 FR 68,871; CFTC Proposal, 77 FR
8356.
---------------------------------------------------------------------------

    In discussing this proposed requirement, the Agencies stated that
bona fide market making-related activity may include certain block
positioning and anticipatory position-taking. More specifically, the
proposal indicated that the bona fide market making-related activity
described in Sec.  ----.4(b)(2)(ii) of the proposed rule would include:
(i) block positioning if undertaken by a trading desk or other
organizational unit of a banking entity for the purpose of
intermediating customer trading; \625\ and (ii) taking positions in
securities in anticipation of customer demand, so long as any
anticipatory buying or selling activity is reasonable and related to
clear, demonstrable trading interest of clients, customers, or
counterparties.\626\
---------------------------------------------------------------------------

    \625\ In the preamble to the proposed rule, the Agencies stated
that the SEC's definition of ``qualified block positioner'' may
serve as guidance in determining whether a block positioner engaged
in block positioning is engaged in bona fide market making for
purposes of Sec.  ----.4(b)(2)(ii) of the proposed rule. See Joint
Proposal, 76 FR 68,871 n.151; CFTC Proposal, 77 FR 8356 n.157.
    \626\ See Joint Proposal, 76 FR 68,871; CFTC Proposal, 77 FR
8356-8357.
---------------------------------------------------------------------------

b. Comments on the Proposed Requirement To Hold Self Out
    Commenters raised many issues regarding Sec.  ----.4(b)(2)(ii) of
the proposed exemption, which would require a trading desk or other
organizational unit to hold itself out as willing to buy and sell the
financial instrument for its own account on a regular or continuous
basis. As discussed below, some commenters viewed the proposed
requirement as too restrictive, while other commenters stated that the
requirement was too permissive. Two commenters expressed support for
the proposed requirement.\627\ A number of commenters provided views on
statements in the proposal regarding indicia of bona fide market making
in more and less liquid markets and the permissibility of block
positioning and anticipatory position-taking.
---------------------------------------------------------------------------

    \627\ See Sens. Merkley & Levin (Feb. 2012); Alfred Brock.
---------------------------------------------------------------------------

    Several commenters represented that the proposed requirement was
too restrictive.\628\ For example, a number of these commenters
expressed concern that the proposed requirement may limit a banking
entity's ability to act as a market maker under certain circumstances,
including in less liquid markets, for instruments lacking a two-sided
market, or in customer-driven, structured transactions.\629\ In
addition, a few commenters expressed specific concern about how this
requirement would impact more limited market-making activity conducted
by banks.\630\
---------------------------------------------------------------------------

    \628\ See infra Part IV.A.3.c.1.c.iii. (addressing these
concerns).
    \629\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);
Morgan Stanley; Barclays; Goldman (Prop. Trading); ABA; Chamber
(Feb. 2012); BDA (Feb. 2012); Fixed Income Forum/Credit Roundtable;
ACLI (Feb. 2012); T. Rowe Price; PUC Texas; PNC; MetLife; RBC; IHS;
SSgA (Feb. 2012).
    \630\ See, e.g., PNC (stating that the proposed rule needs to
account for market making by regional banks on behalf of small and
middle-market customers whose securities are less liquid); ABA
(stating that the rule should continue to permit banks to provide
limited liquidity by buying securities that they feel are suitable
for their retail and institutional customer base by stating that a
bank is ``holding itself out'' when it buys and sells securities
that are suitable for its customers).

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

    Many commenters indicated that it was unclear whether this
provision would require a trading desk or other organizational unit to
regularly or continuously quote every financial instrument in which a
market is made, but expressed concern that the proposed language could
be interpreted in this manner.\631\ These commenters noted that there
are thousands of individual instruments within a given asset class,
such as corporate bonds, and that it would be burdensome for a market
maker to provide quotes in such a large number of instruments on a
regular or continuous basis.\632\ One of these commenters represented
that, because customer demand may be infrequent in a particular
instrument, requiring a banking entity to provide regular or continuous
quotes in the instrument may not provide a benefit to its
customers.\633\ A few commenters requested that the Agencies provide
further guidance on this issue or modify the proposed standard to state
that holding oneself out in a range of similar instruments will be
considered to be within the scope of permitted market making-related
activities.\634\
---------------------------------------------------------------------------

    \631\ This issue is further discussed in Part IV.A.3.c.1.c.iii.,
infra.
    \632\ See, e.g., Goldman (Prop. Trading) (stating that it would
be burdensome for a U.S. credit market-making business to be
required to produce and disseminate quotes for thousands of
individual bond CUSIPs that trade infrequently and noting that a
market maker in credit markets will typically disseminate indicative
prices for the most liquid instruments but, for the thousands of
other instruments that trade infrequently, the market maker will
generally provide a price for a trade upon request from another
market participant); Morgan Stanley; SIFMA et al. (Prop. Trading)
(Feb. 2012); RBC. See also BDA (Feb. 2012); FTN (stating that in
some markets, such as the markets for residential mortgage-backed
securities and investment grade corporate debt, a market maker will
hold itself out in a subset of instruments (e.g., particular issues
in the investment grade corporate debt market with heavy trading
volume or that are in the midst of particular credit developments),
but will trade in other instruments within the group or sector upon
inquiry from customers and other dealers); Oliver Wyman (Feb. 2012)
(discussing data regarding the number of U.S. corporate bonds and
frequency of trading in such bonds in 2009).
    \633\ See Goldman (Prop. Trading).
    \634\ See, e.g., RBC (recommending that the Agencies clarify
that a trading desk is required to hold itself out as willing to buy
and sell a particular type of ``product''); SIFMA et al. (Prop.
Trading) (Feb. 2012) (suggesting that the Agencies use the term
``instrument,'' rather than ``covered financial position,'' to
provide greater clarity); CIEBA (supporting alternative criteria
that would require a banking entity to hold itself out generally as
a market maker for the relevant asset class, but not for every
instrument it purchases and sells); Goldman (Prop. Trading). One of
these commenters recommended that the Agencies recognize and permit
the following kinds of activity in related financial instruments:
(i) Options market makers should be deemed to be engaged in market
making in all put and call series related to a particular underlying
security and should be permitted to trade the underlying security
regardless of whether such trade qualifies for the hedging
exemption; (ii) convertible bond traders should be permitted to
trade in the associated equity security; (iii) a market maker in one
issuer's bonds should be considered a market maker in similar bonds
of other issuers; and (iv) a market maker in standardized interest
rate swaps should be considered to be engaged in market making-
related activity if it engages in a customized interest rate swap
with a customer upon request. See RBC.
---------------------------------------------------------------------------

    To address concerns about the restrictiveness of this requirement,
commenters suggested certain modifications. For example, some
commenters suggested adding language to the requirement to account for
market making in markets that do not typically involve regular or
continuous, or two-sided, quoting.\635\ In addition, a few commenters
requested that the requirement expressly include transactions in new
instruments or transactions in instruments that occur infrequently to
address situations where a banking entity may not have previously had
the opportunity to hold itself out as willing to buy and sell the
applicable instrument.\636\ Other commenters supported alternative
criteria for assessing whether a banking entity is acting as a market
maker, such as: (i) a willingness to respond to customer demand by
providing prices upon request; \637\ (ii) being in the business of
providing prices upon request for that financial instrument or other
financial instruments in the same or similar asset class or product
class; \638\ or (iii) a historical test of market-making activity, with
compliance judged on the basis of actual trades.\639\ Finally, two
commenters stated that this requirement should be moved to Appendix B
of the rule,\640\ which, according to one of these commenters, would
provide the Agencies greater flexibility to consider the facts and
circumstances of a particular activity.\641\
---------------------------------------------------------------------------

    \635\ See, e.g., Morgan Stanley (suggesting that the Agencies
add the phrase ``or, in markets where regular or continuous quotes
are not typically provided, the trading unit stands ready to provide
quotes upon request''); Barclays (suggesting addition of the phrase
``to the extent that two-sided markets are typically made by market
makers in a given product,'' as well as changing the reference to
``purchase or sale'' to ``market making-related activity'' to avoid
any inference of a trade-by-trade analysis). See also Fixed Income
Forum/Credit Roundtable. To address concerns about the requirement's
application to bespoke products, one commenter suggested that the
rule clearly state that a banking entity fulfills this requirement
if it markets structured transactions to its client base and stands
ready to enter into such transactions with customers, even though
transactions may occur on a relatively infrequent basis. See JPMC.
    \636\ See Wells Fargo (Prop. Trading); RBC (supporting this
approach as an alternative to removing the requirement from the
rule, but primarily supporting its removal). See also ISDA (Feb.
2012) (stating that the analysis of compliance with the proposed
requirement must carefully consider the degree of presence a market
maker wishes to have in a given market, which may include being a
leader in certain types of instruments, having a secondary presence
in others, and potentially leaving or entering other submarkets).
    \637\ See SIFMA et al. (Prop. Trading) (Feb. 2012). This
commenter also suggested that such test be assessed at the ``trading
unit'' level. See id.
    \638\ See Goldman (Prop. Trading).
    \639\ See FTN.
    \640\ See Flynn & Fusselman; JPMorgan.
    \641\ See JPMC.
---------------------------------------------------------------------------

    Other commenters took the view that the proposed requirement was
too permissive.\642\ For example, one commenter stated that the
proposed standard provided too much room for interpretation and would
be difficult to measure and monitor. This commenter expressed
particular concern that a trading desk or other organizational unit
could meet this requirement by regularly or continuously making wide,
out of context quotes that do not present any real risk of execution
and do not contribute to market liquidity.\643\ Some commenters
suggested the Agencies place greater restrictions on a banking entity's
ability to rely on the market-making exemption in certain illiquid
markets, such as assets that cannot be reliably valued, products that
do not have a genuine external market, or instruments for which a
banking entity does not expect to have customers wishing to both buy
and sell.\644\ In support of these requests, commenters stated that
trading in illiquid products raises certain concerns under the rule,
including: a lack of reliable data for purposes of using metrics to
monitor a banking entity's market making-related activity (e.g.,
products whose valuations are determined by an internal model that can
be manipulated, rather than an observable market price); \645\ relation
to the last financial crisis; \646\ lack of important benefits to the
real economy; \647\ similarity to prohibited proprietary trading; \648\
and inconsistency with the statute's requirements that market making-
related activity must be ``designed not to exceed the reasonably
expected near

term demands of clients, customers, or counterparties'' and must not
result in a material exposure to high-risk assets or high-risk trading
strategies.\649\
---------------------------------------------------------------------------

    \642\ See, e.g., Occupy; AFR et al. (Feb. 2012); Public Citizen;
Johnson & Prof. Stiglitz; John Reed. See infra note 746 and
accompanying text (responding to these comments).
    \643\ See Occupy.
    \644\ See Occupy; AFR et al. (Feb. 2012); Public Citizen;
Johnson & Prof. Stiglitz; Sens. Merkley & Levin (Feb. 2012); John
Reed.
    \645\ See AFR et al. (Feb. 2012); Occupy.
    \646\ See Occupy.
    \647\ See John Reed.
    \648\ See Johnson & Prof. Stiglitz.
    \649\ See Sens. Merkley & Levin (Feb. 2012) (stating that a
banking entity must have or reasonably expect at least two
customers--one for each side of the trade--and must have a
reasonable expectation of the second customer coming to take the
position or risk off its books in the ``near term''); AFR et al.
(Feb. 2012); Public Citizen.
---------------------------------------------------------------------------

    These commenters also requested that the proposed requirement be
modified in certain ways. In particular, several commenters stated that
the proposed exemption should only permit market making in assets that
can be reliably valued through external market transactions.\650\ In
order to implement such a limitation, three commenters suggested that
the Agencies prohibit banking entities from market making in assets
classified as Level 3 under FAS 157.\651\ One of these commenters
explained that Level 3 assets are generally highly illiquid assets
whose fair value cannot be determined using either market prices or
models.\652\ In addition, a few commenters suggested that banking
entities be subject to additional capital charges for market making in
illiquid products.\653\ Another commenter stated that the Agencies
should require all market making-related activity to be conducted on a
multilateral organized electronic trading platform or exchange to make
it possible to monitor and confirm certain trading data.\654\ Two
commenters emphasized that their recommended restrictions on market
making in illiquid markets should not prohibit banking entities from
making markets in corporate bonds.\655\
---------------------------------------------------------------------------

    \650\ See AFR et al. (Feb. 2012) (stating that the rule should
ban market making in illiquid and opaque securities with no genuine
external market, but permit market making in somewhat illiquid
securities, such as certain corporate bonds, as long as the
securities can be reliably valued with reference to other extremely
similar securities that are regularly traded in liquid markets and
the financial outcome of the transaction is reasonably predictable);
Johnson & Prof. Stiglitz (recommending that permitted market making
be limited to assets that can be reliably valued in, at a minimum, a
moderately liquid market evidenced by trading within a reasonable
period, such as a week, through a real transaction and not simply
with interdealer trades); Public Citizen (stating that market making
should be limited to assets that can be reliably valued in a market
where transactions take place on a weekly basis).
    \651\ See AFR et al. (Feb. 2012) (stating that such a limitation
would be consistent with the proposed limitation on ``high-risk
assets'' and the discussion of this limitation in proposed Appendix
C); Public Citizen; Prof. Richardson.
    \652\ See Prof. Richardson.
    \653\ Two commenters recommended that banking entities be
required to treat trading in assets that cannot be reliably valued
and that trade only by appointment, such as bespoke derivatives and
structured products, as providing an illiquid bespoke loan, which
are subject to higher capital charges under the Federal banking
agencies' capital rules. See Johnson & Prof. Stiglitz; John Reed.
Another commenter suggested that, if not directly prohibited,
trading in bespoke instruments that cannot be reliably valued should
be assessed an appropriate capital charge. See Public Citizen.
    \654\ See Occupy. This commenter further suggested that the
exemption exclude all activities that include: (i) Assets whose
changes in value cannot be mitigated by effective hedges; (ii) new
products with rapid growth, including those that do not have a
market history; (iii) assets or strategies that include significant
imbedded leverage; (iv) assets or strategies that have demonstrated
significant historical volatility; (v) assets or strategies for
which the application of capital and liquidity standards would not
adequately account for the risk; and (vi) assets or strategies that
result in large and significant concentrations to sectors, risk
factors, or counterparties. See id.
    \655\ See AFR et al. (Feb. 2012); Johnson & Prof. Stiglitz.
---------------------------------------------------------------------------

i. The Proposed Indicia
    As noted above, the proposal set forth certain indicia of bona fide
market making-related activity in liquid and less liquid markets that
the Agencies proposed to apply when evaluating whether a banking entity
was eligible for the proposed exemption.\656\ Several commenters
provided their views regarding the effectiveness of the proposed
indicia.
---------------------------------------------------------------------------

    \656\ See supra Part IV.A.3.c.1.a.
---------------------------------------------------------------------------

    With respect to the proposed indicia for liquid markets, a few
commenters expressed support for the proposed indicia.\657\ One of
these commenters stated that while the proposed factors are reasonably
consistent with bona fide market making, the Agencies should add two
other factors: (i) A willingness to transact in reasonable quantities
at quoted prices, and (ii) inventory turnover.\658\
---------------------------------------------------------------------------

    \657\ See Occupy; AFR et al. (Feb. 2012); NYSE Euronext
(expressing support for the indicia set forth in the FSOC study,
which are substantially the same as the indicia in the proposal);
Alfred Brock.
    \658\ See AFR et al. (Feb. 2012).
---------------------------------------------------------------------------

    Other commenters, however, stated that the proposed use of factors
from the SEC's analysis of bona fide market making under Regulation SHO
was inappropriate in this context. In particular, these commenters
represented that bona fide market making for purposes of Regulation SHO
is a purposefully narrow concept that permits a subset of market makers
to qualify for an exception from the ``locate'' requirement in Rule 203
of Regulation SHO. The commenters further expressed the belief that the
policy goals of section 13 of the BHC Act do not necessitate a
similarly narrow interpretation of market making.\659\
---------------------------------------------------------------------------

    \659\ See Goldman (Prop. Trading); SIFMA et al. (Prop. Trading)
(Feb. 2012).
---------------------------------------------------------------------------

    A few commenters expressed particular concern about how the factor
regarding patterns of purchases and sales in roughly comparable amounts
would apply to market making in exchange-traded funds (``ETFs'').
According to these commenters, demonstrating this factor could be
difficult because ETF market making involves a pattern of purchases and
sales of groups of equivalent securities (i.e., the ETF shares and the
basket of securities and cash that is exchanged for them), not a single
security. In addition, the commenters were unsure whether this factor
could be demonstrated in times of limited trading in ETF shares.\660\
---------------------------------------------------------------------------

    \660\ See ICI (Feb. 2012); ICI Global.
---------------------------------------------------------------------------

    The preamble to the proposed rule also provided certain proposed
indicia of bona fide market making-related activity in less liquid
markets.\661\ As discussed above, commenters had differing views about
whether the exemption for market making-related activity should permit
banking entities to engage in market making in some or all illiquid
markets. Thus, with respect to the proposed indicia for market making
in less liquid markets, commenters generally stated that the indicia
should be broader or narrower, depending on the commenter's overall
view on the issue of market making in illiquid markets. One commenter
stated that the proposed indicia are effective.\662\
---------------------------------------------------------------------------

    \661\ See supra Part IV.A.3.c.1.a.
    \662\ See Alfred Brock.
---------------------------------------------------------------------------

    The first proposed factor of market making-related activity in less
liquid markets was holding oneself out as willing and available to
provide liquidity by providing quotes on a regular (but not necessarily
continuous) basis. As noted above, several commenters expressed concern
about a requirement that market makers provide regular quotations in
less liquid instruments, including in fixed income markets and bespoke,
customized derivatives.\663\ With respect to the interaction between
the rule language requiring ``regular'' quoting and the proposal's
language permitting trading by appointment under certain circumstances,
some of these commenters expressed uncertainty about how a market maker
trading only by appointment would be able to satisfy the proposed
rule's regular quotation

requirement.\664\ In addition, another commenter stated that the
proposal's recognition of trading by appointment does not alleviate
concerns about applying the ``regular'' quotation requirement to market
making in less liquid instruments in markets that are not, as a whole,
highly illiquid, such as credit and interest rate markets.\665\
---------------------------------------------------------------------------

    \663\ See supra note 629 accompanying text. With respect to this
factor, one commenter requested that the Agencies delete the
parenthetical of ``but not necessarily continuous'' from the
proposed factor as part of a broader effort to recognize the
relative illiquidity of swap markets. See ISDA (Feb. 2012).
    \664\ See SIFMA et al. (Prop. Trading) (Feb. 2012); CIEBA. These
commenters requested greater clarity or guidance on the meaning of
``regular'' in the instance of a market maker trading only by
appointment. See id.
    \665\ See Goldman (Prop. Trading).
---------------------------------------------------------------------------

    Other commenters expressed concern about only requiring a market
maker to provide regular quotations or permitting trading by
appointment to qualify for the market-making exemption. With respect to
regular quotations, some commenters stated that such a requirement
enables evasion of the prohibition on proprietary trading because a
proprietary trader may post a quote at a time of little interest in a
financial product or may post wide, out of context quotes on a regular
basis with no real risk of execution.\666\ Several commenters stated
that trading only by appointment should not qualify as market making
for purposes of the proposed rule.\667\ Some of these commenters stated
that there is no ``market'' for assets that trade only by appointment,
such as customized, structured products and OTC derivatives.\668\
---------------------------------------------------------------------------

    \666\ See Public Citizen; Occupy. One of these commenters
further noted that most markets lack a structural framework that
would enable monitoring of compliance with this requirement. See
Occupy.
    \667\ See, e.g., Sens. Merkley & Levin (Feb. 2012); Johnson &
Prof. Stiglitz; John Reed; Public Citizen.
    \668\ See, e.g., John Reed; Public Citizen.
---------------------------------------------------------------------------

    The second proposed criterion for market making-related activity in
less liquid markets was, with respect to securities, regularly
purchasing securities from, or selling securities to, clients,
customers, or counterparties in the secondary market. Two commenters
expressed concern about this proposed factor.\669\ In particular, one
of these commenters stated that the language is fundamentally
inconsistent with market making because it contemplates that only
taking one side of the market is sufficient, rather than both buying
and selling an instrument.\670\ The other commenter expressed concern
that banking entities would be allowed to accumulate a significant
amount of illiquid risk because the indicia for market making-related
activity in less liquid markets did not require a market maker to buy
and sell in comparable amounts (as required by the indicia for liquid
markets).\671\
---------------------------------------------------------------------------

    \669\ See AFR et al. (Feb. 2012); Occupy.
    \670\ See AFR et al. (Feb. 2012)
    \671\ See Occupy.
---------------------------------------------------------------------------

    Finally, the third proposed factor of market making in less liquid
markets would consider transaction volumes and risk proportionate to
historical customer liquidity and investment needs. A few commenters
indicated that there may not be sufficient information available for a
banking entity to conduct such an analysis.\672\ For example, one
commenter stated that historical information may not necessarily be
available for new businesses or developing markets in which a market
maker may seek to establish trading operations.\673\ Another commenter
expressed concern that this factor would not help differentiate market
making from prohibited proprietary trading because most illiquid
markets do not have a source for such historical risk and volume
data.\674\
---------------------------------------------------------------------------

    \672\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman
(Prop. Trading); Occupy.
    \673\ See Goldman (Prop. Trading).
    \674\ See Occupy.
---------------------------------------------------------------------------

ii. Treatment of Block Positioning Activity
    The proposal provided that the activity described in Sec.  --
--.4(b)(2)(ii) of the proposed rule would include block positioning if
undertaken by a trading desk or other organizational unit of a banking
entity for the purpose of intermediating customer trading.\675\
---------------------------------------------------------------------------

    \675\ See Joint Proposal, 76 FR 68,871.
---------------------------------------------------------------------------

    A number of commenters supported the general language in the
proposal permitting block positioning, but expressed concern about the
reference to the definition of ``qualified block positioner'' in SEC
Rule 3b-8(c).\676\ With respect to using Rule 3b-8(c) as guidance under
the proposed rule, these commenters represented that Rule 3b-8(c)'s
requirement to resell block positions ``as rapidly as possible'' would
cause negative results (e.g., fire sales) or create market uncertainty
(e.g., when, if ever, a longer unwind would be permitted).\677\
According to one of these commenters, gradually disposing of a large
long position purchased from a customer may be the best means of
reducing near term price volatility associated with the supply shock of
trying to sell the position at once.\678\ Another commenter expressed
concern about the second requirement of Rule 3b-8(c), which provides
that the dealer must determine in the exercise of reasonable diligence
that the block cannot be sold to or purchased from others on equivalent
or better terms. This commenter stated that this kind of determination
would be difficult in less liquid markets because those markets do not
have widely disseminated quotes that dealers can use for purposes of
comparison.\679\
---------------------------------------------------------------------------

    \676\ See, e.g., RBC; SIFMA (Asset Mgmt.) (Feb. 2012); Goldman
(Prop. Trading). See also infra note 735 (responding to these
comments).
    \677\ See RBC (expressing concern about fire sales); SIFMA
(Asset Mgmt.) (Feb. 2012) (expressing concern about fire sales,
particularly in less liquid markets where a block position would
overwhelm the market and undercut the price a market maker can
obtain); Goldman (Prop. Trading) (representing that this requirement
could create uncertainty about whether a longer unwind would be
permissible and, if so, under what circumstances).
    \678\ See Goldman (Prop. Trading).
    \679\ See RBC.
---------------------------------------------------------------------------

    Beyond the reference to Rule 3b-8(c), a few commenters expressed
more general concern about the proposed rule's application to block
positioning activity.\680\ One commenter noted that the proposal only
discussed block positioning in the context of the proposed requirement
to hold oneself out, which implies that block positioning activity also
must meet the other requirements of the market-making exemption. This
commenter requested an explicit recognition that banking entities meet
the requirements of the market-making exemption when they enter into
block trades for customers, including related trades entered to support
the block, such as hedging transactions.\681\ Finally, one commenter
expressed concern that the inventory metrics in proposed Appendix A
would make dealers reluctant to execute large, principal transactions
because such trades would have a transparent impact on inventory
metrics in the relevant asset class.\682\
---------------------------------------------------------------------------

    \680\ See SIFMA (Asset Mgmt.) (Feb. 2012); Fidelity (requesting
that the Agencies explicitly recognize that block trades qualify for
the market-making exemption); Oliver Wyman (Feb. 2012).
    \681\ See SIFMA (Asset Mgmt.) (Feb. 2012).
    \682\ See Oliver Wyman (Feb. 2012). This commenter estimated
that investors trading out of large block positions on their own,
without a market maker directly providing liquidity, would have to
pay incremental transaction costs between $1.7 and $3.4 billion per
year. This commenter estimated a block trading size of $850 billion,
based on a haircut of total block trading volume reported for NYSE
and Nasdaq. The commenter then estimated, based on market interviews
and analysis of standard market impact models provided by dealers,
that the market impact of executing large block orders without
direct market maker liquidity provision would be the difference
between the market impact costs of executing a block trade over a 5-
day period versus a 1-day period--which would be approximately 20 to
50 basis points, depending on the size of the trade. See id.
---------------------------------------------------------------------------

iii. Treatment of Anticipatory Market Making
    In the proposal, the Agencies proposed that ``bona fide market
making-related activity may include taking positions in securities in

anticipation of customer demand, so long as any anticipatory buying or
selling activity is reasonable and related to clear, demonstrable
trading interest of clients, customers, or counterparties.'' \683\ Many
commenters indicated that the language in the proposal is inconsistent
with the statute's language regarding near term demands of clients,
customers, or counterparties. According to these commenters, the
statute's ``designed'' and ``reasonably expected'' language expressly
acknowledges that a market maker may need to accumulate inventory
before customer demand manifests itself. Commenters further represented
that the proposed standard may unduly limit a banking entity's ability
to accumulate inventory in anticipation of customer demand.\684\
---------------------------------------------------------------------------

    \683\ Joint Proposal, 76 FR 68,871; CFTC Proposal, 77 FR 8356-
8357.
    \684\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012)
(expressing concern that requiring trades to be related to clear
demonstrable trading interest could curtail the market-making
function by removing a market maker's discretion to develop
inventory to best serve its customers and adversely restrict
liquidity); Goldman (Prop. Trading); Chamber (Feb. 2012); Comm. on
Capital Markets Regulation. See also Morgan Stanley (requesting
certain revisions to more closely track the statute); SIFMA (Asset
Mgmt.) (Feb. 2012) (expressing general concern that the standard
creates limitations on a market maker's inventory). These comments
are addressed in Part IV.A.3.c.2., infra.
---------------------------------------------------------------------------

    In addition, two commenters expressed concern that the proposal's
language would effectively require a banking entity to engage in
impermissible front running.\685\ One of these commenters indicated
that the Agencies should not restrict anticipatory trading to such a
short time period.\686\ To the contrary, the other commenter stated
that anticipatory accumulation of inventory should be considered to be
prohibited proprietary trading.\687\ A few commenters noted that the
standard in the proposal explicitly refers to securities and requested
that the reference be changed to encompass the full scope of financial
instruments covered by the rule to avoid ambiguity.\688\ Several
commenters recommended that the language be eliminated \689\ or
modified \690\ to address the concerns discussed above.
---------------------------------------------------------------------------

    \685\ See Goldman (Prop. Trading); Occupy. See also Public
Citizen (expressing general concern that accumulating positions in
anticipation of demand opens issues of front running).
    \686\ See Goldman (Prop. Trading).
    \687\ See Occupy.
    \688\ See Goldman (Prop. Trading); ISDA (Feb. 2012); SIFMA et
al. (Prop. Trading) (Feb. 2012).
    \689\ See BoA (stating that a market maker must acquire
inventory in advance of express customer demand and customers expect
a market maker's inventory to include not only the financial
instruments in which customers have previously traded, but also
instruments that the banking entity believes they may want to
trade); Occupy.
    \690\ See Morgan Stanley (suggesting a new standard providing
that a purchase or sale must be ``reasonably consistent with
observable customer demand patterns and, in the case of new asset
classes or markets, with reasonably expected future developments on
the basis of the trading unit's client relationships''); Chamber
(Feb. 2012) (requesting that the final rule permit market makers to
make individualized assessments of anticipated customer demand based
on their expertise and experience in the markets and make trades
according to those assessments); Goldman (Prop. Trading)
(recommending that the Agencies instead focus on how trading
activities are ``designed'' to meet the reasonably expected near
term demands of clients over time, rather than whether those demands
have actually manifested themselves at a given point in time); ISDA
(Feb. 2012) (stating that the Agencies should clarify this language
to recognize differences between liquid and illiquid markets and
noting that illiquid and low volume markets necessitate that swap
dealers take a longer and broader view than dealers in liquid
markets).
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iv. High-Frequency Trading
    A few commenters stated that high-frequency trading should be
considered prohibited proprietary trading under the rule, not permitted
market making-related activity.\691\ For example, one commenter stated
that the Agencies should not confuse high volume trading and market
making. This commenter emphasized that algorithmic traders in general--
and high-frequency traders in particular--do not hold themselves out in
the manner required by the proposed rule, but instead only offer to buy
and sell when they think it is profitable.\692\ Another commenter
suggested the Agencies impose a resting period on any order placed by a
banking entity in reliance on any exemption in the rule by, for
example, prohibiting a banking entity from buying and subsequently
selling a position within a span of two seconds.\693\
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    \691\ See, e.g., Better Markets (Feb. 2012); Occupy; Public
Citizen.
    \692\ See Better Markets (Feb. 2012). See also infra note 742
(addressing this issue).
    \693\ See Occupy.
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c. Final Requirement To Routinely Stand Ready To Purchase And Sell
    Section ----.4(b)(2)(i) of the final rule provides that the trading
desk that establishes and manages the financial exposure must routinely
stand ready to purchase and sell one or more types of financial
instruments related to its financial exposure and be willing and
available to quote, buy and sell, or otherwise enter into long and
short positions in those types of financial instruments for its own
account, in commercially reasonable amounts and throughout market
cycles, on a basis appropriate for the liquidity, maturity, and depth
of the market for the relevant types of financial instruments. As
discussed in more detail below, the standard of ``routinely'' standing
ready to purchase and sell one or more types of financial instruments
will be interpreted to account for differences across markets and asset
classes. In addition, this requirement provides that a trading desk
must be willing and available to provide quotations and transact in the
particular types of financial instruments in commercially reasonable
amounts and throughout market cycles. Thus, a trading desk's activities
would not meet the terms of the market-making exemption if, for
example, the trading desk only provides wide quotations on one or both
sides of the market relative to prevailing market conditions or is only
willing to trade on an irregular, intermittent basis.
    While this provision of the market-making exemption has some
similarity to the requirement to hold oneself out in Sec.  --
--.4(b)(2)(ii) of the proposed rule, the Agencies have made a number of
refinements in response to comments. Specifically, a number of
commenters expressed concern that the proposed requirement did not
sufficiently account for differences between markets and asset classes
and would unduly limit certain types of market making by requiring
``regular or continuous'' quoting in a particular instrument.\694\ The
explanation of this requirement in the proposal was intended to address
many of these concerns. For example, the Agencies stated that the
proposed ``indicia cannot be applied at all times and under all
circumstances because some may be inapplicable to the specific asset
class or market in which the market-making activity is conducted.''
\695\ Nonetheless, the Agencies believe that certain modifications are
warranted to clarify the rule and to prevent a potential chilling
effect on market making-related activities conducted by banking
entities.
---------------------------------------------------------------------------

    \694\ See supra Part IV.A.3.c.1.b. (discussing comments on this
issue). The Agencies did not intend for the reference to ``covered
financial position'' in the proposed rule to imply a single
instrument, although commenters contended that the proposal may not
have been sufficiently clear on this point.
    \695\ Joint Proposal, 76 FR 68,871; CFTC Proposal, 77 FR 8356.
---------------------------------------------------------------------------

    Commenters represented that the requirement that a trading desk
hold itself out as being willing to buy and sell ``on a regular or
continuous basis,'' as was originally proposed, was impossible

to meet or impractical in the context of many markets, especially less
liquid markets.\696\ Accordingly, the final rule requires a trading
desk that establishes and manages the financial exposure to
``routinely'' stand ready to trade one or more types of financial
instruments related to its financial exposure. As discussed below, the
meaning of ``routinely'' will account for the liquidity, maturity, and
depth of the market for a type of financial instrument, which should
address commenter concern that the proposed standard would not work in
less liquid markets and would have a chilling effect on banking
entities' ability to act as market makers in less liquid markets. A
concept of market making that is applicable across securities,
commodity futures, and derivatives markets has not previously been
defined by any of the Agencies. Thus, while this standard is based
generally on concepts from the securities laws and is consistent with
the CFTC's and SEC's description of market making in swaps,\697\ the
Agencies note that it is not directly based on an existing definition
of market making.\698\ Instead, the approach taken in the final rule is
intended to take into account and accommodate the conditions in the
relevant market for the financial instrument in which the banking
entity is making a market.
---------------------------------------------------------------------------

    \696\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);
Morgan Stanley; Barclays; Goldman (Prop. Trading); ABA; Chamber
(Feb. 2012); BDA (Feb. 2012); Fixed Income Forum/Credit Roundtable;
ACLI (Feb. 2012); T. Rowe Price; PUC Texas; PNC; MetLife; RBC; SSgA
(Feb. 2012). Some commenters suggested alternative criteria, such as
providing prices upon request, using a historical test of market
making, or a purely guidance-based approach. See SIFMA et al. (Prop.
Trading) (Feb. 2012); Goldman (Prop. Trading); FTN; Flynn &
Fusselman; JPMC. The Agencies are not adopting a requirement that
the trading desk only provide prices upon request because the
Agencies believe it would be inconsistent with market making in
liquid exchange-traded instruments where market makers regularly or
continuously post quotes on an exchange. With respect to one
commenter's suggested approach of a historical test of market
making, this commenter did not provide enough information about how
such a test would work for the Agencies' consideration. Finally, the
final rule does not adopt a purely guidance-based approach because,
as discussed further above, the Agencies believe it could lead to an
increased risk of evasion.
    \697\ See Further Definition of ``Swap Dealer,'' ``Security-
Based Swap Dealer,'' ``Major Swap Participant,'' ``Major Security-
Based Swap Participant'' and ``Eligible Contract Participant'', 77
FR 30596, 30609 (May 23, 2012) (describing market making in swaps as
``routinely standing ready to enter into swaps at the request or
demand of a counterparty'').
    \698\ As a result, activity that is considered market making
under this final rule may not necessarily be considered market
making for purposes of other laws or regulations, such as the U.S.
securities laws, the rules and regulations thereunder, or self-
regulatory organization rules. In addition, the Agencies note that a
banking entity acting as an underwriter would continue to be treated
as an underwriter for purposes of the securities laws and the
regulations thereunder, including any liability arising under the
securities laws as a result of acting in such capacity, regardless
of whether it is able to meet the terms of the market-making
exemption for its activities. See Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

i. Definition of ``Trading Desk''
    The Agencies are adopting a market-making exemption with
requirements that generally focus on a financial exposure managed by a
``trading desk'' of a banking entity and such trading desk's market-
maker inventory. The market-making exemption as originally proposed
would have applied to ``a trading desk or other organizational unit''
of a banking entity. In addition, for purposes of the proposed
requirement to report and record certain quantitative measurements, the
proposal defined the term ``trading unit'' as each of the following
units of organization of a banking entity: (i) Each discrete unit that
is engaged in the coordinated implementation of a revenue-generation
strategy and that participates in the execution of any covered trading
activity; (ii) each organizational unit that is used to structure and
control the aggregate risk-taking activities and employees of one or
more trading units described in paragraph (i); and (iii) all trading
operations, collectively.\699\
---------------------------------------------------------------------------

    \699\ See Joint Proposal, 76 FR 68,957; CFTC Proposal, 77 FR
8436.
---------------------------------------------------------------------------

    The Agencies received few comments regarding the organizational
level at which the requirements of the market-making exemption should
apply, and many of the commenters that addressed this issue did not
describe their suggested approach in detail.\700\ One commenter
suggested that the market-making exemption apply to each ``trading
unit'' of a banking entity, defined as ``each organizational unit that
is used to structure and control the aggregate risk-taking activities
and employees that are engaged in the coordinated implementation of a
customer-facing revenue generation strategy and that participate in the
execution of any covered trading activity.'' \701\ This suggested
approach is substantially similar to the second prong of the Agencies'
proposed definition of ``trading unit'' in Appendix A of the proposal.
The Agencies described this prong as generally including management or
reporting divisions, groups, sub-groups, or other intermediate units of
organization used by the banking entity to manage one or more discrete
trading units (e.g., ``North American Credit Trading,'' ``Global Credit
Trading,'' etc.).\702\ The Agencies are concerned that this commenter's
suggested approach, or any other approach applying the exemption's
requirements to a higher level of organization than the trading desk,
would impede monitoring of market making-related activity and detection
of impermissible proprietary trading by combining a number of different
trading strategies and aggregating a larger volume of trading
activities.\703\ Further, key requirements in the market-making
exemption, such as the required limits and risk management procedures,
are generally used by banking entities for risk control and applied at
the trading desk level. Thus, applying them at a broader organizational
level than the trading desk would create a separate system for
compliance with this exemption designed to permit a banking entity to
aggregate disparate trading activities and apply limits more generally.
Applying the conditions of the exemption at a more aggregated level
would allow banking entities more flexibility in trading and could
result in a higher volume of trading that could contribute modestly to
liquidity.\704\ Instead of taking that approach, the Agencies have
determined to permit a broader range of market making-related
activities that can be effectively controlled by building on risk
controls used by trading desks for business purposes. This will allow
an individual trader to use instruments or strategies within limits
established in the compliance program to confidently trade in the type
of financial instruments in which his or her trading desk makes a
market. The Agencies believe this addresses concerns that uncertainty
would negatively impact liquidity. It also addresses concerns that
applying the market-making exemption at a higher level of organization
would reduce the effectiveness of the requirements in the final rule
aimed at ensuring that the quality and character of trading is
consistent with market

making-related activity and would increase the risk of evasion.
Moreover, several provisions of the final rule are intended to account
for the liquidity, maturity, and depth of the market for a given type
of financial instrument in which the trading desk makes a market. The
final rule takes account of these factors to, among other things,
respond to commenters' concerns about the proposed rule's potential
impact on market making in less liquid markets. Applying these
requirements at an organizational level above the trading desk would be
more likely to result in aggregation of trading in various types of
instruments with differing levels of liquidity, which would make it
more difficult for these market factors to be taken into account for
purposes of the exemption (for example, these factors are considered
for purposes of tailoring the analysis of reasonably expected near term
demands of customers and establishing risk, inventory, and duration
limits).
---------------------------------------------------------------------------

    \700\ See Wellington; SIFMA et al. (Prop. Trading) (Feb. 2012).
    \701\ Morgan Stanley.
    \702\ See Joint Proposal, 76 FR 68,957 n.2.
    \703\ See, e.g., Occupy (expressing concern that, with respect
to the proposed definition of ``trading unit,'' an ``oversized''
unit could combine significantly unrelated trading desks, which
would impede detection of proprietary trading activity).
    \704\ The Agencies recognize that the proposed rule's
application to a trading desk ``or other organizational unit'' would
have provided banking entities with this type of flexibility to
determine the level of organization at which the market-making
exemption should apply based on the entity's particular business
structure and trading strategies, which would likely reduce the
burdens of this aspect of the final rule. However, for the reasons
noted above regarding application of this exemption to a higher
organizational level than the trading desk, the Agencies are not
adopting the ``or other organizational unit'' language.
---------------------------------------------------------------------------

    Thus, the Agencies continue to believe that certain requirements of
the exemption should apply to a relatively granular level of
organization within a banking entity (or across two or more affiliated
banking entities). These requirements of the final market-making
exemption have been formulated to best reflect the nature of activities
at the trading desk level of granularity.
    As explained below, the Agencies are applying certain requirements
to a ``trading desk'' of a banking entity and adopting a definition of
this term in the final rule.\705\ The definition of ``trading desk'' is
similar to the first prong of the proposed definition of ``trading
unit.'' The Agencies are not adopting the proposed ``or other
organizational unit'' language because the Agencies are concerned that
approach would have provided banking entities with too much discretion
to independently determine the organizational level at which the
requirements should apply, including a more aggregated level of
organization, which could lead to evasion of the general prohibition on
proprietary trading and the other concerns noted above. The Agencies
believe that adopting an approach focused on the trading desk level
will allow banking entities and the Agencies to better distinguish
between permitted market making-related activities and trading that is
prohibited by section 13 of the BHC Act and, thus, will prevent evasion
of the statutory requirements, as discussed in more detail below.
Further, as discussed below, the Agencies believe that applying
requirements at the trading desk level is balanced by the financial
exposure-based approach, which will address commenters' concerns about
the burdens of trade-by-trade analyses.
---------------------------------------------------------------------------

    \705\ See final rule Sec.  ----.3(e)(13).
---------------------------------------------------------------------------

    In the final rule, trading desk is defined to mean the smallest
discrete unit of organization of a banking entity that buys or sells
financial instruments for the trading account of the banking entity or
an affiliate thereof. The Agencies expect that a trading desk would be
managed and operated as an individual unit and should reflect the level
at which the profit and loss of market-making traders is
attributed.\706\ The geographic location of individual traders is not
dispositive for purposes of the analysis of whether the traders may
comprise a single trading desk. For instance, a trading desk making
markets in U.S. investment grade telecom corporate credits may use
trading personnel in both New York (to trade U.S. dollar-denominated
bonds issued by U.S.-incorporated telecom companies) and London (to
trade Euro-denominated bonds issued by the same type of companies).
This approach allows more effective management of risks of trading
activity by requiring the establishment of limits, management
oversight, and accountability at the level where trading activity
actually occurs. It also allows banking entities to tailor the limits
and procedures to the type of instruments traded and markets served by
each trading desk.
---------------------------------------------------------------------------

    \706\ For example, the Agencies expect a banking entity may
determine the foreign exchange options desk to be a trading desk;
however, the Agencies do not expect a banking entity to consider an
individual Japanese Yen options trader (i.e., the trader in charge
of all Yen-based options trades) as a trading desk, unless the
banking entity manages its profit and loss, market making, and
hedging in Japanese Yen options independently of all other financial
instruments.
---------------------------------------------------------------------------

    In response to comments, and as discussed below in the context of
the ``financial exposure'' definition, a trading desk may manage a
financial exposure that includes positions in different affiliated
legal entities.\707\ Similarly, a trading desk may include employees
working on behalf of multiple affiliated legal entities or booking
trades in multiple affiliated entities. Using the previous example, the
U.S. investment grade telecom corporate credit trading desk may include
traders working for or booking into a broker-dealer entity (for
corporate bond trades), a security-based swap dealer entity (for
single-name CDS trades), and/or a swap dealer entity (for index CDS or
interest rate swap hedges). To clarify this issue, the definition of
``trading desk'' specifically provides that the desk can buy or sell
financial instruments ``for the trading account of a banking entity or
an affiliate thereof.'' Thus, a trading desk need not be constrained to
a single legal entity, although it is permissible for a trading desk to
only trade for a single legal entity. A trading desk booking positions
in different affiliated legal entities must have records that identify
all positions included in the trading desk's financial exposure and
where such positions are held, as discussed below.\708\
---------------------------------------------------------------------------

    \707\ See infra note 724 and accompanying text. Several
commenters noted that market-making activities may be conducted
across separate affiliated legal entities. See, e.g., SIFMA et al.
(Prop. Trading) (Feb. 2012); Goldman (Prop. Trading).
    \708\ See infra note 727 and accompanying text.
---------------------------------------------------------------------------

    The Agencies believe that establishing a defined organizational
level at which many of the market-making exemption's requirements apply
will address potential evasion concerns. Applying certain requirements
of the market-making exemption at the trading desk level will
strengthen their effectiveness and prevent evasion of the exemption by
ensuring that the aggregate trading activities of a relatively limited
group of traders on a single desk are conducted in a manner that is
consistent with the exemption's standards. In particular, because many