The Volcker rule, codified as part of the Dodd-Frank Act, pertains to all depository institutions and those affiliated with or regulated as banks (“banking entities”). The rule, now finalized by all five applicable federal agencies, prohibits banking entities from engaging in proprietary or own-account trading of certain securities, derivatives and options, among other restrictions.

Specifically, the Volcker rule provisions apply to banking entities of all shapes and sizes, although some smaller banks may be relieved of certain compliance program and reporting obligations. Therefore, community and regional banks, in addition to the obviously covered banking entities, have the arduous task of determining how to adequately monitor and manage covered activities.

It would be a mistake for smaller and less complex banking entities to immediately, and without additional review, conclude that their activities are not covered, nor can any reclassification of coverage occur as a result of agency-related activities, and therefore that the Volcker rule would not apply.

This is true because the final rule expands the definition of trading activities that are captured under the rule. For example, the rule articulates a broader scope of what constitutes “market-making” activities, which is expressly excluded from the rule’s prohibitions. However, it is necessary to also consider any residual positions or portfolios that may result from agency-transacted or seemingly market-making activities that may fall into the lens of proprietary prohibition through reclassification or residual activities.

In other words, to the extent an agency transaction does not exactly match any close-out, hedge or cover, a residual position may become a regulatory-covered position under the rule. This is a genuine example of the narrow distinction between market-making activities and proprietary trading that will likely cause significant confusion, and will require in-depth analysis.

Initial analysis by banking entities will need to consider any inadvertent or intended overage that would result from any agency transaction.

For instance, the final rule expressly states that banks can build up positions to meet “the reasonably expected near-term demands of clients, customers or counterparties.” A conflict may occur upon the condition that an intended transaction, on behalf of a given customer, may in positional terms fall outside of the exact or even estimated “near term” demands. In this instance, the position, or portfolio may be construed as proprietary based on the difference between the anticipated demands and the actual demands.

Simply put, any market making inspired transaction must be accompanied by the requisite automation to accurately predict demand scenarios. As a result, any residual extraneous position can then be calibrated and closely aligned with the regulatory mandate of “reasonable expectation of clients, customers and counterparties.” This process enhancement is consistent with the joint regulatory guidance which suggests that banking entities may rely on their own independent analysis of reasonable expectation concerning positional demands.

Therefore, adherence to a well-aligned exposure analysis system that continuously monitors residual positions (and portfolios) is necessary to remain compliant with the Volcker rule. Residual monitoring of agency transactions are crucial because the hedging activities of any banking entity’s portfolio as well as  calibrated market-making activities and purported extendable agency activities will likely be strictly scrutinized on a continual basis. Automation will certainly lead the way as banks develop risk sensitivities that articulate a qualitative mitigation standard that will reduce the burden of the Volcker rule.