New U.S. rules on banks' proprietary trading activities will make it harder for Britain to issue government bonds, Chancellor George Osborne has told the U.S. Federal Reserve.

In a January 23 letter to Fed Chairman Ben Bernanke, Osborne said he was worried that the exemption for primary dealers of sovereign debt was too narrow.

Japan and Canada have already complained about the effect the proposed Volcker rule might have on their government bond markets, while the European Commission is also set to do so, according to reports.

The rule, named after former Federal Reserve Chairman Paul Volcker, aims to prevent banks from carrying out speculative trades for their own profit and is designed to stop banks taking risks with customer deposits.

Although we understand that the primary legislation makes an exemption for market-making activities, in practice the regulations would appear to make it more difficult and costlier to provide market-making services in non-U.S. sovereign markets, Osborne wrote in the letter, which was published on the U.S. Securities and Exchange Commission website on Tuesday.

Any consequent withdrawal of market-making services by banks would reduce liquidity in sovereign markets, which in turn would engender greater volatility and make it more difficult, riskier and costlier for countries such as the UK to issue and distribute their debt, Osborne added.

The new rules will make 'warehousing' government bonds for sale at a later date more problematic and could not come at a worse time for Britain, which will have to issue more bonds in the next few years as its economy weakens.

Britain's gilt-edged market makers, the 21 banks that distribute government bonds, told the UK Debt Management Office earlier this year they had strong concerns about the U.S. legislation, which could make it less commercially viable for them to be primary dealers.

The government has revised up its gilt issuance plans for the current 2011/12 fiscal year by more than 11 billion pounds to 178.9 billion pounds, and is likely to have to raise even more in 2012/13.

After the letter was published, Britain's Treasury told Reuters it was working with all concerned parties to limit any fall-out from the new rules.

We're working with the banks to mitigate any adverse or unintended consequences of international regulation, a Treasury spokesman said.

(Reporting by Fiona Shaikh; Editing by Catherine Evans)