On April 20, 2017, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) issued a Consent Order to Deutsche Bank AG after finding deficiencies in the bank’s Volcker Rule compliance program, imposing a civil money penalty of $19.71 million. This is the first time that the Federal Reserve has found a violation of the Volcker Rule, which requires banking entities with total assets greater than $10 billion to establish compliance programs reasonably designed to ensure and monitor compliance with Volcker Rule requirements.
While proprietary trading activities are prohibited under the Volcker Rule, there are two main exemptions that allow depository banks and their affiliates to trade or underwrite financial instruments without being in violation: (i) the underwriting exemption and (ii) the market-making exemption. In order for a bank that is subject to the Volcker Rule to avail itself of these exemptions, its trading desks must make sure that their trading activities are designed not to exceed the reasonably expected near-term demands (“RENTD”) of clients, customers and counterparties. The Federal Reserve found Deutsche Bank AG to be in violation of the Volcker Rule pertaining to its RENTD methodologies under the market-making exemption.
Under the market-making exemption, RENTD is considered when setting risk and position limits for (i) market-making inventory, (ii) products used to manage risk in connection with market-making activity, (iii) risk factors relating to overall exposure of the trade desk’s portfolio, and (iv) inventory holding periods. RENTD methodologies are used to create these limits and provide evidence that a trading desk’s positions are correlated to customer activity and are estimates of future customer demand.
Market-making RENTD has been a challenge for banks to capture since the data that is necessary to make these estimates had never been collected by most banks before the Volcker Rule, and the data itself is complex and can span multiple trading systems depending on the size of the bank. For example, the market-making exemption applies to trades with “customers” only. Therefore, trading desks must bifurcate trades that will use the market-making exemption into customer and noncustomer trades for historical data purposes. Additionally, the market-making RENTD estimation is done on a trade-by-trade basis, making compliance even more complex.
In issuing its Consent Order, the Federal Reserve determined that Deutsche Bank AG failed to establish a compliance program reasonably designed to ensure and monitor compliance with Volcker Rule requirements, finding the following:
The Consent Order requires an increase in senior management oversight and enhanced internal controls and the Volcker Rule compliance program. With regard to these two main areas of focus, the bank will need to submit a written plan that is acceptable to the Federal Reserve within sixty (60) days of the Consent Order. At a minimum, the plan must include the following: