Proposal could have far-reaching and unintended consequences, opponents say.

Industry participant are mounting a full-court press against the Volcker rule, saying that it could have far-reaching and unintended consequences.

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.

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.

“If the proposal is adopted in its current form, it can reasonably be expected that covered banking entities will be forced to severely curtail their traditional market making activities for all but the most liquid of securities, said Peter Kraus, chairman and CEO of AllianceBernstein, in a letter to regulators.

“While this may be the intended effect of the proposal, it ignores the fact that much of the current market making activities in this country are provided by covered banking entities,” said Kraus.

The short time frame provided for covered banking entities to implement the Dodd-Frank Act almost insures a dramatic reduction in liquidity, he said. Long term, a potential unintended consequence is that much of the market making activity may over time relocated offshore.

“Restrictions on firms’ abilities to conduct market-making activity will discourage investment, limit credit availability and increase the cost of capital,” said Tim Ryan, president and CEO of Sifma. “This will no doubt stifle economic growth and job creation. The failure of MF Global is a prime example of how markets should work, not an excuse to broaden the scope of the Volcker Rule.”

In the wake of the MF Global collapse, however, many think the banks should be subject to even tighter Volcker Rule restrictions. This is a mistake, said Ryan.

MF Global would not have been subject to the mandatory limits on trading contained in the proposed Volcker Rule, he said. Current futures regulations and laws already address the use of client funds for a firm’s own trading purposes, known as proprietary trading, and these laws should be enforced.

The industry’s primary concern with the Volcker Rule as proposed has nothing to do with the stand-alone proprietary trading at MF Global, which many banks have already stopped doing.

“Our concern is its extended, and in many cases unintended, impact on these traditional market-making activities at the expense of the basic functions of U.S. markets,” Ryan said.

“The government should not be responsible for protecting companies and sophisticated investors from failing. America cannot regulate itself into ensuring that no company ever fails,” he said.  The markets and federal regulators simply must be prepared when they do.

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.