The Volcker Rule was created as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”).
Under Title VI Section 619 of the Dodd-Frank Act, a banking entity shall not engage in proprietary trading or acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund. The Volcker Rule was named after Paul Volcker, who first proposed this prohibition while he served as Chairman of the Federal Reserve from 1979 to 1987.
Prohibition on Proprietary Trading. Banking institutions are prohibited from acting as the principal for a trading account in any transaction to purchase or sell a security, derivative, commodity future, or other financial instrument as defined under the regulations. The intent behind the rule is to create a divide between banking and securities firms. Banks are in the business of making loans to their customers and not underwriting securities. When the banks started securitizing loans, the line between a bank and a securities institution blurred.
Prohibition on Investing in Hedge Funds and Private Equity. Hedge funds and private equity are notoriously volatile and highly illiquid investments. Many private equity funds have long lock-up periods, during which investors cannot redeem their interests for years. If an investor needs to quickly convert investments to cash to cover their short-term debt obligations, investments in a hedge fund or private equity do not provide that short-term liquidity. For this reason, banks are prohibited from making these investments in covered funds unless an exception applies.