Banking Interpretations

NYBL 96(1)
NYBL 200

To: Deputy Superintendent Stone
From: Assistant Counsel Sullivan

August 11, 2010

Subject: [---] - New York Branch

Proposed Energy Derivatives Activities


Whether the Banking Department should approve the proposal of the New York Branch (the “New York Branch”) of [---] (the “Bank”) to trade certain equity derivatives as an agent for the Bank’s Head Office (the “Head Office”)?


Yes, provided that the Bank furnishes the Banking Department with the additional information specified below.


In a letter from its counsel1 clarified by subsequent E-mails2, the Bank has proposed that its New York Branch3 act as an agent for its Head Office to trade customer-driven,4 cash-settled equity derivatives transactions.  These equity derivatives transactions would initially include single-name, basket and index-based options, single-underlying barrier options, and volatility flow products, including variance swaps, VIX futures and options, and timer options.5  

All trades would be booked at the Head Office — i.e., the Head Office would be the counter party to each derivatives transaction.  Agreements with counter parties and confirmations would be in the name of the Head Office.6   Although profits and losses and risks would be monitored primarily from the New York Branch, no positions would be booked at the New York Branch, and consequently, the positions would not be reflected on the Call Report of the New York Branch.

After a transaction were concluded with a customer, the equity derivatives trader at the New York Branch would be responsible for hedging the trade.  Each equity derivatives transaction would be matched by an offsetting transaction or hedged on a portfolio basis.  All such hedging transactions would be conducted by the New York Branch acting as agent for the Head Office, and all such transactions would be booked at the Head Office.  The New York Branch would not engage in hedging activities for its own account.

The proposed activities would be conducted in accord with the risk management policies and procedures established by the Head Office.  These policies and procedures would include, inter alia: risk assessment of contemplated transactions and counter parties; aggregate trading limits; segregation of duties as between trading, confirmation and record keeping functions, and procedures for the review of each trader’s activity.  Risk reports would be produced for the New York positions booked at Head Office and would be forwarded to the New York Branch risk management team on a daily basis.    Such activities would also be subject to compliance policies and procedures that would include, inter alia: BSA/AML/OFAC review of all counter parties and conformity with applicable record keeping requirements.

The proposed equity derivatives activities at the New York Branch would be reviewed and approved by the New Product Committee (“NPC”) at the New York Branch as well as at the analogous NPC at the Head Office.  This review process would consider business strategy, credit risk, market risk, accounting and financial risk, regulatory risk, legal and compliance risk, tax risk, operational risk and other risks.

The proposed equity derivatives trading activities would also be reviewed and approved by the Global Chief Risk Officer at the Head Office. The U.S. Audit Group would review the new equity derivatives activities to make certain that the new activities had been properly approved and such activities were properly monitored. 

Limits governing the size of trading positions of the New York Branch-based equity derivatives traders would be established and approved by risk management at the Head Office (“Head Office Risk Control”).  Adherence to such position limits would be monitored by the New York Branch risk management personnel (“New York Risk Control”) and reviewed by Head Office Risk Control.  The equity derivatives traders would have a separate portfolio within the Head Office trading system and would enter into trades for the account of the Head Office.   The exposures of the equity derivatives traders would be monitored on a daily basis by New York Risk Control which would immediately highlight to the Head Office any breaches of position limits. 

Each equity derivatives transaction would also be subject to counter party credit risk limits that were established for customers of the Bank.  The respective Credit Committees of the New York Branch and Head Office would be actively involved in establishing counter party risk limits for equity derivatives activities.  All counter party risk limits would be approved by the New York or Head Office Credit Committee.  In this regard, overall counter party credit risk limits would be established by the Head Office for the Bank’s customers.  The New York Branch would have delegated authority to approve counter party credit risk limits below specified delegation levels.

The Bank has provided extensive information with respect to the agency relationship between the New York Branch and the Head Office.  The Bank has provided a draft EDA Transactional Services Agreement which delineates those activities which would be conducted in the New York Branch and those which would be conducted at the Head Office.  Appendix C of that draft agreement refers to various documents under which credit, market, product and other limits would be established.  The Bank should also make these documents available to the Banking Department if it has not already done so.


Generally, under the Banking Law, the powers (except for deposit-taking) of a New York licensed branch of a foreign bank (“New York branch”) are co-extensive with those of a New York State-chartered bank (“New York bank”).  Provided that certain conditions had been satisfied,7 New York banks and, therefore, New York branches have been permitted to act as principal in offering derivative products including swaps, forward contracts and option agreements where the underlying reference asset was one in which a New York bank would not be permitted to invest.8

In 2008,9 the Banking Department determined that such a New York branch could act as agent for its bank’s London office and market, structure and trade derivatives contracts.10  The issue is, therefore, whether a New York branch that is acting only as agent must meet the same requirements that would apply if it were acting as principal.  Subsequently, the Banking Department determined that a New York branch that is acting as agent should generally meet the prudential standards that would be applicable if that branch were acting as principal.11

These prudential standards require, among other things, that the transactions be customer driven.  A New York branch may not engage in proprietary trading of such derivative products.12  Moreover, the branch should enter derivative transactions only where the client has an “underlying business” reason to use the transaction for hedging purposes.13

Still, the requirements are different when a New York branch is only acting as agent.  When acting as principal, a New York branch must hedge its exposure on either a matched-book or portfolio basis and must develop policies and procedures to address the various risks entailed in hedging.  A transaction conducted by a New York branch as agent for a foreign office of a foreign bank might have to be hedged by the foreign bank under the law of its jurisdiction.  However, such hedging would not have to be effected by the New York branch either as agent or principal.

The Bank’s submission did not state that the derivatives transactions that are to be booked in the Head Office constitute a permissible activity for the Head Office.

The Dodd-Frank Act:

The submission did not address the effect of the subsequently enacted Dodd-Frank Act.  Moreover, because many provisions of that Act will have to be clarified by future regulation, it is not yet possible to determine its impact definitively.

For example, because the New York Branch would be acting solely as agent it is not clear whether the New York Branch would be considered a security-based swap dealer or whether, because of the activity conducted through its New York Branch, the Bank would be considered as such.  Nevertheless, it would appear that the New York Branch would be subject to extensive record keeping and recording requirements14 and to rigorous standards of business conduct.15

Additional Information:

In the case of those derivatives transactions that would be impermissible for the New York Branch as principal, the Bank should provide a specific justification for the New York Branch’s acting as agent as well as a heightened level of assurance that the New York Branch would be insulated from the risks taken by the Head Office as principal.  In any event, the Bank should show that the derivatives transactions that are to be booked in the Head Office are a permissible activity for the Head Office.

To the extent that it has not already done so, the Bank should make available to the Banking Department the disclosure materials that the New York Branch intends to provide to its prospective counter parties and customers, which disclosure materials should at a minimum make clear that the New York Branch is acting only as agent for the Head Office.

Finally, the Bank should indicate its awareness of the provisions of the Dodd-Frank Act and on an ongoing basis provide the Banking Department with its plans to comply with that Act as such plans are developed.

Noted: M.E.G.

A variance swap is a type of swap that is based on variance rather than volatility.   Volatility is typically measured as the standard deviation of returns from a security or market index. Variance is the square of this standard deviation.

VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index.  This index, which endeavors to show the market's expectation of 30-day volatility in the S&P 500 index, is constructed using the implied volatilities of a wide range of S&P 500 index options. 

The price of a plain vanilla option is a function of the implied volatility expected in the market.   In contrast, the purchaser of a timer option is able to specify both a tentative maturity and an expected volatility.   If the actual volatility exceeds that specified, the maturity will be shortened and vice versa.

In this context, Federal assistance will include Federal deposit insurance and any credit from the Federal Reserve except the credit that is available widely in “unusual and exigent circumstances” under Section 13(3)(A) of the Federal Reserve Act. 12 U.S.C. § 343(3)(A).   A Federally–insured New York bank will be subject to this swap push-out provision while a New York branch will be able to avoid the application of this provision by not availing itself of Federal assistance.

  1. Letter from [---], to Regina Stone, Deputy Superintendent of Banks dated March 8, 2010.
  2. E-mails from [---] to Assistant Counsel John Sullivan dated July 23, 2010 and August 10, 2010.
  3. The Bank currently maintains the New York Branch at two existing offices in New York City.  It has received approval to establish a third office, but the establishment of that office is beyond the scope of this memorandum.
  4. A customer-driven transaction is one entered into for another party’s valid and independent business purpose. OCC Interpretive Letter No.1018 n.3.   In such a transaction, the Bank’s activities would not involve positioning — i.e., the Bank would neither seek nor take market risk with respect to price of the underlying asset.  Instead, it would engage in financial intermediation to enable its customers to hedge their risks.  Letter from Deputy Superintendent and Counsel Sara A. Kelsey to [---] dated April 25, 2003.
  5. A barrier option is a type of option whose payoff depends on whether or not the underlying asset has reached or exceeded a predetermined price.
  6. At present, the Bank conducts a global equity derivatives business which is managed by the Head Office and supported by infrastructure located at the Head Office.
  7. For example, the conditions applicable to dealing in commodity derivatives contracts were reviewed in the letter from First Deputy Superintendent David T. Halvorson to [---] dated November 14, 1988.
  8. Section 716 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203 (2010), (the “Dodd-Frank Act”) contains a swap push-out provision whose effectiveness will be phased in starting July 21, 2012.   This swap push-out provision will generally prohibit granting any Federal assistance to any swap dealer or security-based swap dealer that is dealing in swaps whose underling asset would not be eligible for investment by a national bank.  The rules for the eligibility of investments are analogous for New York banks.
  9. Memorandum from Rosanne Notaro to Examiner Nosikovsky dated August 15, 2008.
  10. The derivatives contracts were based on various property indices
  11. Memorandum from Assistant Counsel Sullivan to Deputy Superintendent Stone dated June 24, 2010.
  12. Letter from Deputy Superintendent David S. Fredsall to [---] dated February 22, 2006.
  13. Memorandum from Principal Risk Management Specialist Peter A. Jaskierny to Chief Risk Management Specialist [---] dated September 10, 2008.
  14. Section 764(f) and (g) of the Dodd-Frank Act will require each security-based swap dealer to comply with record keeping and recording requirements that are to be adopted by the Securities and Exchange Commission (the “SEC”).
  15. Section 764(h) of the Act will require each such dealer to comply with business conduct standards to be adopted by the SEC, which standards will have to:
    • Establish a duty for such dealer to verify that any counter party meets the eligibility standards for an eligible contract participant.
    • Generally require disclosure by such dealer to each counter party about the material risks and characteristics of the swap, any material incentives, or conflicts of interest that such dealer may have in connection with the swap, and the daily mark of the transaction.
    • Establish a duty for such dealer to communicate in a fair and balanced manner based on principles of fair dealing and good faith.
    • Establish such other standards and requirements as the SEC may determine are appropriate.

Such dealers will have additional responsibilities with respect to special entities.  Special entities include federal agencies, states, state agencies and other political subdivisions of a state as well as certain pension plans and endowments.