The liquidity of mutual funds and exchange-traded funds, as well as their operating costs, could be collateral damage, depending on how the Volcker Rule precluding proprietary trading by banks gets implemented, Investment Company Institute general counsel Karrie McMillan will argue Monday at the 2012 ICI Mutual Funds and Investment Management Conference in Phoenix.

Mutual funds and other investment companies were not the target of the Volcker Rule, enacted into law with the passage of the Dodd-Frank Wall Street Reform Act in July 2010. But “funds are not immune” to the implementation of it, she will assert in her opening day address.

“The proposed implementation spills over into nearly every corner of finance,’’ she will say, according to an advance copy of her speech.

Under the proposed implementation, banks could be precluded from acting as market makers for fixed-income products, derivatives and securities, she contends. A “likely result of that could be sharply reduced liquidity” in bonds, derivatives and thinly traded equities, according to McMillan.

This will mean wider spreads between bid prices and asking prices, as well as higher trading costs, for mutual funds.

In the exchange-traded fund field, the bank could be precluded from acting as “authorized participants” in the market. Translation: They would be blocked from creating or redeeming large blocks of shares in such funds.

They could also be precluded from acting as market makers in exchange-traded funds.

“Shrinking the number of firms eligible to act as authorized participants and market makers will create bad outcomes for ETF investors,’’ including making it hard to keep share prices close to net asset values, she said.

The Volcker proposal is so broadly written that it would treat some U.S. registered funds—and virtually all non-U.S. funds—as hedge funds, McMillan contends. That could bar banks from sponsoring or investing in any of these funds. And make it difficult to find trading partners, particularly from other countries.

The bottom line, she will argue:

“The proposal to implement the Volcker Rule could impair liquidity and trading in U.S. markets; prevent global funds from competing with similar foreign-owned funds; and impede the organization, sponsorship, and normal activities of U.S. funds. That’s quite a lot of damage.’’

Tom Steinert-Threlkeld writes for Securities Technology Monitor.