NEW YORK - Federal Reserve Governor Daniel Tarullo conceded Wednesday that extensive new regulations of bank involvement in proprietary trading, hedge funds and other investment entities will "undoubtedly affect" banks' ability to trade securities and derivative instruments.

Tarullo, testifying before a House Financial Services subcommittee, also acknowledged the complexity of trying to regulate such activities, calling it a "difficult task" to distinguish between what is prohibited and what is permitted by the so-called "Volcker Rule" that was included in the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act.

The financial services industry has been up in arms over the Rule, named after former Fed Chairman Paul Volcker, contending that its trading restrictions will costs hundreds of billions of dollars, damage market liquidity and hurt the economy.

The Volcker Rule, technically Section 619 of the Dodd-Frank Act, prohibits banking firms from engaging in proprietary trading and from acquiring an ownership interest in, sponsoring, or having certain relationships with a hedge fund or private equity fund.

The Fed, together with the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Securities and Exchange Commission, have proposed 298 pages of regulations to implement the restrictions. Tarullo defended the "nuanced" approach of the agencies' proposed regulations, while saying that firms will have a "long conformance period" with which to comply and that the agencies hope to provide "more specific guidance" on what they can do once they have had a chance to collect more data.

Seeking to clarify the extent to which the Rule will limit proprietary trading, Tarullo said "the statute applies only to positions taken by a banking entity as principal for the purpose of making short-term profits; it does not apply to positions taken for long-term or investment purposes."

And he said "the statute contains a number of exemptions, including for underwriting, market making-related activities, and risk-mitigating hedging activities." He said the proposed rules incorporate those exemptions and added that the agencies can "permit additional activities if they would promote and protect safety and soundness of the banking entity and the financial stability of the United States."

The Volcker Rule prohibition on bank involvement with hedge funds and private equity funds is "quite broad," said Tarullo, although there too exceptions are allowed.

The statute (and the implementing regulation) "quite broadly prohibits any banking entity that serves as the investment manager, adviser, or sponsor to a covered fund, or that organizes and offers a covered fund, from engaging in certain transactions with the fund, including lending to, or purchasing assets from, the fund," he said.

"The statute also prohibits otherwise permissible trading and investment activities when there is a material conflict of interest with customers, clients, or counterparties, or when the activity results in an exposure to high-risk assets or trading strategies," he added.

Tarullo suggested there are ambiguities inherent in the legislation that make it difficult for the agencies to implement.

"One of the more difficult tasks in implementing the statutory prohibitions is distinguishing between prohibited proprietary trading activities and permissible market-making activities," he said, adding that this distinction is "important because of the key role that market makers play in facilitating liquid markets in securities, derivatives, and other assets."

Tarullo said the distinction between pure proprietary trading and market making is "straightforward" at "the ends of the spectrum."

At one end, he said it's not hard to identify trading activities carried out by a "discrete business unit" of the bank for its own short-term profit and not on behalf of a customer. Such firms "can readily identify and wind down these activities," he said.

On the other end of the spectrum, Tarullo gave as an example "a pure agency-based market maker that acts as an intermediary, instantaneously matching a large pool of buyers and sellers of an underlying asset without ever having to take a position in the asset itself."

But "instances of such riskless market making in our trading markets are rare," he said. "In actual markets, buyers and sellers arrive at different times, in staggered numbers and often have demands for similar but not identical assets. Market makers hold inventory and manage exposures to the assets in which they make markets to ensure that they can continuously serve the needs of their customers."

The problem for the regulators is that "in the broad middle that exists between these two clear examples, the distinction between prohibited proprietary trading and permissible market making can be difficult to draw, because these activities share several important characteristics."

"In both activities, the banking entity generally acts as principal in trading the underlying position, holds that position for only a relatively short period of time, and enjoys profits (and suffers losses) from any price variation in the position over the period the position is held," he explained. "Thus, the purchase or sale of a specific block of securities is not obviously permissible or forbidden based solely on the features of the transaction itself."

Dodd-Frank attempts to make the distinction by looking to "the purpose of the trade and the intent of the trader," but Tarullo said "these subjective characteristics can be difficult to discern in practice, particularly in the context of complex global trading markets in which a firm may engage in thousands or more transactions per day."

"A similar challenge attaches to efforts to distinguish a hedging trade from a proprietary trade," he said.

To deal with these challenges, the Fed and its fellow regulators have proposed a three-part framework for implementing the Volcker Rule:

1) an explanation of the factors the agencies expect to use to differentiate prohibited activities from permitted activities;

2) a requirement that banking entities with significant trading activities implement a program to monitor their activities to ensure compliance with the statute, and

3) data collection and reporting requirements, to facilitate both compliance monitoring and the development of more specific guidance over time.

Tarullo said the agencies "will use their supervisory and examination processes to monitor compliance with the statute."

He said they will be collecting quantitative data, which will be used to "identify activity that merits special scrutiny."

Tarullo said the agencies will aim to "reduce the burden of the proposed rule on smaller, less-complex banking entities."

Banks have railed against the proprietary trading prohibition in the Volcker Rule, and Tarullo acknowledged it "will undoubtedly affect the trading behavior of banking entities." But he said that was Congress's intent and said "the task of the agencies is to implement Congressional intentions ... as efficiently and effectively as possible.

That won't be easy, he admitted.

"The approach taken in the proposed rulemaking is concededly not a simple one," he said, but the approach chosen "seemed the most feasible."

He said the agencies could have taken one of two alternative approaches: one, to "articulate high-level principles for differentiating prohibited and permitted activities and then leave it to the firms to self-report violations" or two, to "establish definitive bright lines for determining whether an activity is permitted or prohibited."

But Tarullo said the agencies chose a "more nuanced framework" that is "designed to realize some of the advantages of both of these approaches while minimizing their potential adverse effects."

There is a long way to go until the Volcker Rule is fully implemented, and Tarullo suggested regulatory modifications might be made.

Dodd-Frank provides for "a long conformance period," and "the agencies have proposed to use that conformance period to study the effects of the statutory prohibitions on the activities of banking entities before the Volcker Rule is fully implemented," he said.

"We are hopeful that the data collection and reporting required in our proposal will eventually facilitate more specific guidance on market-making, hedging, and other exemptions from the general prohibition," he said. "After the Volcker Rule becomes fully effective, we would continue to monitor the effects of the rule and look for opportunities to refine it."

And Tarullo added that "the Federal Reserve is more than open to alternatives that would be superior to the approach proposed."

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