Canadians alarmed by Volcker Ruleís ìunintended consequencesî

Canadian politicians, regulators, financial institutions and lobby groups are making their voices heard in protest against the "Volcker Rule,î the U.S. legislative response to the financial skullduggery of 2008. The Volcker Rule ó Section 619 of the Dodd-Frank Act ó will prohibit U.S. financial institutions from proprietary trading, that is, trading for their own accounts, and from owning, sponsoring or having certain relationships with a hedge fund or private equity fund.

There is no doubt the proposed rule is well intended but how the rule will be applied come July 21 has stirred up controversy globally about U.S. protectionism and aroused concerns about "unintended consequences.î Canadian and international leaders fear the proposed rule may undermine rather than support efforts to get the global financial system on sound footing.

The Investment Funds Institute of Canada (IFIC), representing Canadian's mutual fund industry, weighed in on the eve of the deadline for comment. Its concern: the proposed rule's definitions of "covered fundsî and "resident of the United States.î IFIC wants public mutual funds clearly distinguished from hedge funds, private equity funds and covered funds, and Canadian snowbirds and other temporary U.S. residents excluded from the definition of "resident of the United States.î

"As drafted, the Volcker Rule erects a barrier between the Canadian mutual fund industry and its Canadian clients,î IFIC president Joanne De Laurentiis said in a press release, "especially among our retiree, snowbird population.î

In his letter to U.S. Secretary of the Treasury Timothy Geithner, federal Finance Minister Jim Flaherty reiterated De Laurentiis's concerns: "Without a change to the rule, a Canadian covered banking entity could be precluded from continuing to sponsor such a fund if it had unit holders resident in the U.S., even temporarily.î

But Flaherty and Bank of Canada Governor Mark Carey also have broader concerns that centre on the liquidity and resiliency of Canadian financial markets. In his Feb. 13 letter to Ben Bernanke, chairman of the U.S. Federal Reserve, Carney pointed out: "The proposed rule appears to extend well beyond U.S.-insured depository institutions and imposes significant restrictions on Canadian banking entities by limiting their use of U.S.-based resources, personnel and market infrastructure and by preventing them from trading with U.S. counterparties.î

Says Flaherty in his letter: "The Volcker rule could apply to transactions between Canadian banks that are simply facilitated by U.S.-based financial infrastructure, such as U.S. clearing houses.î

Carney points out three potential consequences of the proposed rule:

ï Canadian banks market-making and risk-management activities may be limited.

ï Trading in Canadian government bonds may be impaired, restricting competition and liquidity in these markets.

ï The use of U.S.-based global market infrastructure may be curtailed, hindering progress in implementing global initiatives to promote financial stability.

He recommends two changes:

ï The "solely outside of the United Statesî exception should be predicated upon whether the activity entails risk for a U.S.-insured depository institution and not incidental connections with U.S. entities or infrastructure.

ï Canadian government securities, including securities issued or guaranteed by the federal and provincial governments, should be exempt from proprietary trading restrictions.