Bankruptcy filing of MF Global rekindles debate over proprietary trading.

The bankruptcy filing of MF Global is likely to cause rumblings regarding the Volcker rule, experts say.

“It’s clear that the Volcker rule was designed to prevent these exact sorts of trades, Andrew Stoltmann, a Chicago-based attorney, told Markets Media.

“Specifically, the Volcker rule would prevent brokerage firms from gambling with their own capital, which is what MF Global did  by placing huge bets on European sovereign debt.”

The rule, issued by federal banking regulators and the SEC, prohibits banking entities from engaging in prop trading, i.e., in trading for their own account.
Although not a banking entity, and there not subject to the Volcker rule, MF Global was engaging in the kinds of activities that the Volcker rule is intended to prevent.

“It’s déjà vu all over again, albeit on a much smaller scale in comparison to Lehman,” said Stoltmann. “There’s  no reason why big banks can’t do the same kind of thing.”

The proposed rule, whose comment period expires on Jan. 13, 2012, implements exemptions for underwriting and market making-related activities. For each of these permitted activities, the proposed rule provides a number of requirements that must be met in order for a banking entity to rely on the applicable exemption.

At the same time, the rule permits banks to engage in trading activities that support “client-oriented” financial services, which include underwriting, market making, and traditional asset management services.

That introduces a potential loophole through which prop trading could continue under the guise of legitimate market making or underwriting.

Exemptions are also included for risk-mitigation hedging, which would require banks to document, at the time the transaction is executed, the hedging rationale for the transaction, and for trading in U.S. government bonds and debt for government-sponsored entities.