Signs of a Split Among Volcker Rule's Opponents

(Reuters) -- As pro-business groups clamor to convince regulators to overhaul their draft of the controversial Volcker rule, fault lines are emerging within the opposition over just what a revamped draft should look like.

The Volcker rule -- named for former Federal Reserve Chairman Paul Volcker -- was mandated by the 2010 Dodd-Frank financial oversight law to prevent banks that receive government backstops like deposit insurance from making risky trades with their own funds.

Heralded by the left as a means to rein in the risk-taking that nearly toppled the financial system in 2007-2009, the Volcker rule has been excoriated by the right, who warn it could take liquidity out of the market and make it hard for firms to raise capital.

The rule -- whose first draft was proposed by regulators in October -- would have the biggest impact on large banks such as Goldman Sachs and Morgan Stanley .

But as business groups, banks and others rush to complete comment letters before the February 13 deadline, a split has emerged Aabout the best approach to make sure the ban on proprietary trades doesn't also capture trades that banks make for their customers' benefit, known as "market making", or firms' own portfolio hedging.

One camp says it's better to give regulators more discretion so they can apply a common-sense approach when distinguishing proprietary trades from permissible market-making trades.

Another camp wants "bright lines" distinguishing the two, arguing it will bring clarity to the fuzzy rule.

Tom Quaadman, vice president of the Chamber of Commerce's Center for Capital Markets Competitiveness, said the divide comes down to a natural tension between attorneys writing the comment letters and traders whose activities will be curtailed.

"Traditionally, lawyers always like bright lines because you can really define where you are within the scope of a law or regulation," said Quaadman.

He added that practitioners, "who are involved in the trading every day would probably want to have some more discretion."

A bank lobbyist who declined to be named said banks stood to gain from a vaguer approach.

"If you do a principles-based approach ... it is open to a lot more interpretation and justification which is fine from our perspective."

HUNDREDS OF PAGES, QUESTIONS

When Volcker pitched the proprietary trading ban to President Barack Obama, the letter was reportedly three pages long.

But when regulators dropped their proposal in October, it was roughly 300 pages, with more than 350 questions for public comment, including on how the government should write the market-making exemption.

The financial community griped that it was too complex and too vague, especially for a reform set to go live in July of this year.

The divide about how the final rule should look played out recently at a Chamber of Commerce event about the rule's impact.

Hal Scott, a professor of international financial systems at Harvard University, argued for a flexible approach in which banks would also be allowed to explain to regulators why their trades fit within the market-making exemption.

"I don't think you can write rules about this because I think at each firm, there will be different kinds of specific little problems," Scott said.

"I don't see any way out of trying to give (regulators) more discretion and trying to police that discretion."

On the other side was Eugene Scalia, a partner at Gibson, Dunn & Crutcher who last year helped business groups win a court ruling striking down the U.S. Securities and Exchange Commission's proxy access rule that would have made it easier to shareholders to nominate directors.

Scalia argued for certainty and bright lines.

"The agencies need to provide some clear guidance and the business community needs to know if they act within certain bounds that they will not be second guessed," Scalia said.

The divide has a long history in jurisprudence.

The phrase "I know it when I see it," made famous by Supreme Court Justice Potter Stewart in his concurring opinion in the 1964 obscenity case Jacobellis v. Ohio, came to represent the argument for the flexible approach.

That adhoc view of distinguishing between art and pornography would be replaced by "the Miller test," a more specific three-prong obscenity test created in the 1973 case of Miller v. California.

Volcker himself, testifying at a Senate Banking Committee hearing in 2010, said regulators can spot excessive risk-taking like the common man can identify something as pornography.

Harvard Professor Scott said the two sides are not polarized; they are engaged in a fair intellectual debate.

"Gene understands my point, I understand his," Scott told Reuters about his back-and-forth with Scalia, whose father is Supreme Court Justice Antonin Scalia.

But the Harvard professor would not budge on his view of the rule's need for a broader, simpler approach.

"All we see is that 298 pages is not making it any clearer for us," he said.

(Reporting By Karey Wutkowski; Editing by Bernard Orr)