Volcker rule

The Volcker rule takes its name from former Federal Reserve Chairman Paul Volcker, who originally proposed the concept. Congress incorporated this rule into the to address risks in the banking system. The rule restricts a broad category of financial institutions from certain high-risk activities.

These restricted institutions, called "banking entities," include U.S. banks and all their worldwide subsidiaries. The rule also applies to foreign banks that operate in the United States, along with their organizational affiliates. The Volcker rule prohibits these banking entities from sponsoring, investing in, or owning most categories of private funds, known as "covered funds." However, the rule includes specific carve-outs and limited exemptions.

A hedge fund generally qualifies as a covered fund under specific conditions. The fund must meet the legal definition of an investment company under the . However, the fund must rely on statutory exceptions found in either or of that Act to avoid registration requirements.

For U.S. banking entities and their worldwide subsidiaries, the definition is broader. It includes any offshore hedge fund that is not offered or sold to U.S. residents, provided that fund would need the same exceptions if it were marketed in the United States.

The rule excludes certain fund structures from the covered fund definition. Credit-focused funds fall outside the restrictions if their investment portfolios consist exclusively of specific assets. These assets include loans, debt obligations, , and assets tied to loan origination or management. The funds may also hold permissible interest rate and currency derivatives. Banking entities that manage qualifying credit funds still face other restrictions, including prohibitions on and asset-backed securitization issuance.

The rule defines ownership interest broadly. It includes equity and partnership positions. It also encompasses debt instruments that exhibit specified "ownership characteristics." These characteristics particularly include rights regarding investment manager removal or replacement.

Most CLO debt instruments grant noteholders such rights, so they initially appeared to constitute ownership interests. However, regulatory guidance provided important clarification. Replacement rights triggered only by default events or equivalent acceleration circumstances fall outside ownership interest scope.

Most CLO management agreements activate replacement rights for cause-based manager actions. These situations fall short of default conditions. As a result, CLO notes avoided classification as ownership interests before 2020 amendments.

Banking entities cannot maintain positions in covered funds, with some narrow exceptions. This restriction applies only when a banking entity acts as principal. The rule does not restrict investments held in fiduciary, custodial, broker, or agent capacities for unaffiliated third parties.

Both U.S. and non-U.S. banking entities receive two specific ownership allowances when organizing and offering covered funds. The "de minimis exception" permits them to retain up to 3% of total fund ownership interests. The "seeding exception" allows ownership of up to 100% during the fund's first year of establishment. During this seeding period, the banking entity must actively recruit unaffiliated investors to reduce its stake. The entity must comply with the 3% threshold by year-end, though it may request up to two one-year extensions.

Banking entities face an additional restriction across all their covered fund holdings. Their aggregate investments in covered funds cannot exceed 3% of their .

Banking entities that assume sponsorship roles over covered funds must follow specific regulatory requirements. Sponsorship occurs in several situations. The banking entity may function as the fund's or . It may direct a majority of governance positions. The entity may also share its corporate name or variations with the fund for marketing purposes.

Performance compensation earned by banking entities serving as fund investment advisers generally avoids classification as covered fund ownership. However, several conditions must be satisfied. The interest must exist solely to share fund profits as performance-based compensation. All allocated profits must be distributed promptly. If profits are retained, they cannot participate in subsequent fund returns. The banking entity must contribute no capital beyond de minimis levels. Finally, the interest must remain non-transferable except to affiliates.

Five federal banking regulators jointly established implementing regulations for the Volcker rule. These agencies include the SEC, CFTC, Federal Reserve Board, FDIC, and OCC. The regulators carved loan securitizations entirely from the covered fund definition.

This exemption permits banking entities to make unrestricted investments in (CLOs) that qualify as loan securitizations. Banking entities can also engage in unlimited transactional activity with these CLOs. However, they must invest only in underlying loans and avoid holding securities beyond short-term cash instruments.

The federal banking regulators made significant changes to the Volcker rule in 2020. They proposed amendments in January 2020 and finalized them by June 25, 2020. The amendments took effect on October 1, 2020.

These amendments refined and clarified the covered fund provisions in several ways. They permit loan securitizations to maintain up to 5% of portfolio value in non-loan debt securities and other permissible assets. The amendments refined the "ownership interest" definition to exclude certain senior debt instruments. They established clearer guidance on "cash equivalent" treatment.

The amendments also expanded the carve-out for removal rights. They now permit removal rights for "cause-based" manager actions that are distinct from default scenarios. The regulators introduced new fund exclusions for several categories. These include credit funds, venture capital funds meeting criteria, and customer facilitation and family wealth management vehicles.

These changes modernized the rule's application while maintaining its core objective. The Volcker rule continues to restrict speculative banking entity trading and high-risk covered fund investments.