Wall Street faces intrusive new government oversight of tradingafter U.S. regulators issued what they billed as a stricter Volckerrule today, imposing restrictions designed to prevent blowups whileleaving many of the details to be worked out later.

The Federal Reserve, the Federal Deposit Insurance Corp. (FDIC),and three other agencies are set to sign off today on theproprietary trading ban, which has been contested by JPMorgan Chase& Co., Goldman Sachs Group Inc., and their industry allies formore than three years. Agencies were proceeding with plans torelease the rule in Washington even as a snowstorm forced thefederal government to close.

Wall Street's lobbying paid off in part. Regulators granted abroader exemption for banks' market-making desks, on the conditionthat traders aren't paid in a way that rewards proprietary trading,according to the final rule released today. The regulation alsoexempts some securities tied to foreign sovereign debt. At the sametime, regulators gave banks less leeway for bets considered hedgesfor other risks.

“This provision of the Dodd-Frank Act has the importantobjective of limiting excessive risk-taking by depositoryinstitutions and their affiliates,” Fed Chairman Ben Bernanke saidtoday in a statement. “The ultimate effectiveness of the rule willdepend importantly on supervisors, who will need to find theappropriate balance while providing feedback to the board on howthe rule works in practice.”

The Fed gave banks a delay until July 21, 2015 to comply withrule. Beginning June 30, 2014, banks with $50 billion inconsolidated assets and liabilities must report quantitativeinformation about their trading.

The rule is named for Paul Volcker, the former Fed chairmancredited with taming rampant inflation in the 1970s and who servedas a top adviser to President Barack Obama. Volcker, 86, proposedthe ban as a means of restoring stability to Wall Street followingthe 2008 financial crisis, arguing that banks that benefit fromfederal deposit insurance and discount borrowing shouldn't bepermitted to take risks that could trigger a taxpayer-fundedgovernment bailout.

The rule, enshrined by the Dodd-Frank Act of 2010, allowsexemptions for market-making and some hedging, and defines limitsfor banks' investments in private equity and hedge funds. Theversion issued today is 71 pages long, with an additional 850-pagepreamble.

“Nobody went to jail after the Wall Street meltdown,” said JimAntos, a Hong Kong-based analyst at Mizuho Securities Asia Ltd. inHong Kong. “And maybe, the particular way they're wording thisensures that nobody is ever going to go to jail. You're gettingdiplomatic immunity and you don't even have to be a foreigndiplomat. Fantastic.”

The biggest U.S. banks slid in pre-market trading. JPMorganChase & Co. declined 0.4 percent to $56.28 at 8:56 a.m. in NewYork, and Bank of America Corp. shares fell 0.3 percent to $15.53.Goldman Sachs Group Inc. slid 0.7 percent to $166.45 and MorganStanley fell 0.2 percent to $30.32.

Fine Print

With Wall Street banks having already shut proprietary tradingdesks in anticipation of the rule, its impact rests largely in thefine print—how regulators address other banking activities,primarily market-making and hedging.

The rule by the Fed, FDIC, Securities and Exchange Commission(SEC), Commodity Futures Trading Commission (CFTC), and Office ofthe Comptroller of the Currency sets parameters for how banks maybuy and sell financial products for clients and manage their ownrisks in the process.

Wall Street's five largest firms had as much as $44 billion inrevenue at stake on the outcome of just one part of the debate—howmarket-making is defined and exempted—according to data for theyear ended Sept. 30. JPMorgan, the biggest U.S. lender by assets,had as much as $11.4 billion riding on the answer.

Here are summaries of five of the rule's major provisions:

Making markets. The Volcker rule bansbanks, including New York-based Goldman Sachs and Morgan Stanley,from trading to profit for their own accounts, while allowing themto continue making markets for clients. Distinguishing betweenthose two practices has been one of the most difficult tasks forregulators.

In the final rule, regulators eased the criteria banks must meetto qualify for the market-making exemption. To receive theexemption, a trading desk must both buy and sell contracts or enterinto both long and short positions of those instruments for its ownaccount.

The trades must not exceed, on an ongoing basis, the “reasonablyexpected near-term demands of clients.” The rule instructs banks todetermine that demand based on historical data and other marketfactors. Further, the rule requires that compensation arrangementsnot be designed to reward prohibited trading.

Bankers became concerned about the rule's potential to ban bigparts of their business almost immediately after Dodd-Frank waspassed in 2010. The 2011 draft included a list of criteria to bemet for trading to be exempted as market-making.

Fed Governor Daniel Tarullo said the rule had been “simplifiedsomewhat, particularly by reducing the number of metrics that willbe used in the reporting and analysis of trading data.”

Industry lobbyists urged the exemption be widened, sayingregulators needed to recognize that banks routinely buy and sellstocks, bonds, and derivatives and build up inventories to helpclients when they eventually place orders. Restricting thosepractices would hurt companies selling bonds, for example. Bankswere joined by asset managers such as Vanguard Group Inc. andAllianceBernstein Holding LP in warning that a narrow exemptioncould unsettle markets.

Portfolio hedging. In the final rule,regulators require banks to demonstrate on an ongoing basis thattheir trades hedge specific risks in order to win an exemption fromthe Volcker rule.

The banks must analyze and independently test that their hedges“may reasonably be expected” to reduce the identified risk, thedraft says. Banks will need to show that a hedge “demonstrablyreduces or otherwise significantly mitigates one or more specific,identifiable risks,” the rule says.

The final rule requires banks to have an “ongoing recalibrationof the hedging activity by the banking entity to ensure that thehedging activity” is not prohibited.

The hedging provision became central to the Volcker rule debateafter JPMorgan lost $6.2 billion last year in bets on creditderivatives known as the London Whale. The trades, conducted in theU.K. by the bank's chief investment office and nicknamed for theirmarket impact, were described by JPMorgan executives as a portfoliohedge. The bank's synthetic credit portfolio produced about $2.5billion of revenue in the five years before 2012, according to aSenate subcommittee report on the bets.

Bart Chilton, a Democratic CFTC commissioner who said Nov. 20that he planned to vote against the rule because it was too weak,said today that it had been strengthened enough since to win hissupport.

“The language has been solidified tightly to avoid loopholes,”Chilton said in a statement. “When people say this version of theVolcker rule will stop circumstances like the London Whale, thisongoing recalibration provision is exactly what will help avoidsimilar debacles.”

Senator Carl Levin, 79, the Michigan Democrat who leads thePermanent Subcommittee on Investigations, joined other Democratsand some regulators in pushing for a narrower definition of hedgingafter the JPMorgan trades. Tarullo, the Fed governor responsiblefor financial regulation, called the trades a “real world” case tobe considered as the rule was drafted.

Three months after the losses were disclosed in 2012, JPMorganChairman and Chief Executive Officer Jamie Dimon, 57, toldlawmakers that the Volcker ban “may very well have stopped parts ofwhat this portfolio morphed into.”

Still, Wall Street pressed regulators to allow banks leeway inhow they manage assets and liabilities with hedges. “An overlyrestrictive Volcker rule would curtail market liquidity, harminvestors, and dampen economic growth,” said Kenneth Bentsen,president of the Securities Industry and Financial MarketsAssociation, Wall Street's biggest lobby group, in a Dec. 5e-mailed statement.

Sovereign debt. The buying and sellingof securities backed by a foreign sovereign will be permittedtrading under certain circumstances, according to the rule. Thatexemption includes securities issued by foreign central banks andapplies to U.S. banks with overseas operations as well as foreignfirms with affiliates in the U.S.

The initial Volcker rule draft drew international criticism forits reach into banks based overseas as well as for its impact onforeign sovereign debt markets.

The push-back started in late 2011 after the Volcker proposalexempted trading in U.S. government securities while covering debtissued by foreign countries. Officials from Canada, Japan, and theU.K. sent letters to U.S. financial regulators and the TreasuryDepartment saying the measure would harm their ability to fundgovernments.

Michel Barnier, the European Union's financial services chief,complained to then-Treasury Secretary Timothy F. Geithner about therule's “extraterritorial consequences.” Canadian and Mexicanbankers and government officials said the proprietary trading banwould violate the North American Free Trade Agreement's guaranteethat banks be allowed to deal equally in U.S. and Canadian debtobligations.

Regulators also allowed more flexibility for overseas banks.They will be exempt from the ban for trades accounted for outsidethe U.S. so long as their employees deciding to buy and sellcontracts are also located outside the country. The final rule alsofrees overseas banks from the ban for trades they conduct onU.S.-based exchanges and clearinghouses, and for trades they havewith foreign operations of U.S. banks.

Fund investments. The proprietarytrading rule seeks to limit banks' speculative bets in another way:by curbing their investments in private equity, hedge funds, andcommodity pools.

U.S. banks have already begun cutting their stakes, with furtherreductions needed to meet the law's limit of 3 percent of Tier 1capital invested in the funds. For example, Goldman Sachs cut itsinvestment in such funds to $14.9 billion as of Sept. 30, down from$15.4 billion when Dodd-Frank was passed.

Regulators granted broader exemptions for some types of funds.Under the final rule, joint ventures, issuers of asset-backedsecurities, and wholly-owned subsidiaries are among exemptfunds.

In an effort to limit the provision's impact, bankrepresentatives told regulators too many types of investments wereincluded in the 2011 proposal. The draft restrictions went beyondtraditional private equity and hedge funds, they said.

Bankers argued that using such a broad definition would captureinvestment vehicles used when loans are bundled into securities, aswell as commodity pools and funds based overseas. In a February2012 letter to regulators, lobbying groups for the largest bankscalled the covered funds definition the “most far-reaching flaw” inthe proposal.

CEO responsibility. Apart from thespecific limits on bank investments and trading practices, theVolcker rule includes efforts at changing part of the culture oftrading on Wall Street.

The approach was underscored by a speech in Washington last weekby Treasury Secretary Jacob J. Lew, who said executives in chargeof financial firms need to ensure that the “tone at the top”reflects a strong desire to prevent violating the rule.

Toward that end, the rule has a section entitled “responsibilityand accountability,” which details how banks should set upcompliance programs. They must have written procedures that areapproved by the board of directors as well as the senior managementof the bank, according to the rule.

The board and top managers “are responsible for setting andcommunicating an appropriate culture of compliance,” the rulesaid.

The centerpiece of the governance changes is a requirement thatCEOs “annually attest in writing” that the company has “proceduresto establish, maintain, enforce, review, test, and modify” thecompliance program.

The wording will be a relief to Wall Street chiefs who wereconcerned that they would have to personally guarantee that theirfirms were in compliance with the rule, according to peoplefamiliar with the banks' thinking. Executives already file asimilar certification with the Financial Industry RegulatoryAuthority, a self-regulatory group for brokerage firms.

The certification wasn't part of the Volcker rule when it wasfirst proposed two years ago; it was added to send a signal thatregulators weren't bending to a massive lobbying campaign byfinancial firms, according to two officials familiar with therule.

Supervisory Focus

In the end, after hundreds of pages outlining numerouswhat-if's, exemptions, and special circumstances, the rulereiterates that banks will now have to prove to supervisors thatthey are adhering to the overriding principle that Volcker andObama put forward in 2010 as a way to prevent another financialmeltdown.

According to documents released by the Fed, the rule prohibits“any transaction or activity” exposing banks to high-risk assets orstrategies “that would substantially increase the likelihood thatthe banking entity would incur a substantial financial loss orwould pose a threat to the financial stability of the UnitedStates.”

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