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SEC Fight Against Big Money Enters Darkness: Street Whispers

Earlier in August, another SEC proposal, a change to stock trading that could help bring loosely regulated dark pools and high frequency traders to more regulated exchanges, was overwhelmed by the existing opacity of markets. The SEC proposal came after nearly a decade of market share losses by exchanges like NYSE Euronext (NYX) and Nasdaq (NDAQ) to more opaque high frequency trading venues, algorithmic trading breeding grounds that were implicated in the May 2010 "Flash Crash" and multiple instances of subsequent abnormal stock trading.

In July, the SEC approved its Retail Liquidity Program to fight the continued rise of dark pools by allowing the NYSE to open its own dark pool trading venue to popular electronic brokerages like E-Trade (ETFC), TD Ameritrade (AMTD) and Charles Schwab (SCHW). To catastrophic results, the program's first trading led to a $440 million loss at Knight Capital (KCG) which in a flash put that company on life support.

NYSE Euronext launched the RLP in August with what it argues are investor protections of public data feeds and increased regulation. In a lobbying effort for the RLP, Duncan Niederauer, the chief executive of NYSE Euronext took to the Financial Times to note that the program would return stock trading from opaque outfits to more trustworthy exchanges, citing figures like the 50 dark pool exchanges across the U.S. and the 40% of overall market trading that is channeled to them.

However, amid Knight's trading loss, competing RLP programs from BATS Global Markets -- a more opaque trading venue to the "Big Board" -- and the expected launch of other similar programs from other dark pools like Direct Edge, signal an industry-wide effort to block the SEC efforts to shine a light on high-frequency stock trading.

The industry, it appears, is upset by the SEC's perceived favoritism of more regulated exchanges like NYSE over their off-exchange trading venues scattered across the U.S. and in nanosecond fast trading hamlets like Kansas City and Weekawken, N.J.

Efforts like BATS' RLP and the expectation of similar moves by other venues imply a strategy to fight darkens with extra darkeness in stock market trading, undermining what was one of the SEC's few tangible solutions to the "Flash Crash" after over two years of study.

So where does this leave the SEC and its chairwoman? Clearly dispirited. In a New York Times interview, Schapiro called the stalled money market reform a "tragedy" for investors.

Tragedy implies a bitter end, though, and one would hope the SEC's failure at reform may yet be a test of newly created market regulations that respond to the financial crisis.

In the case of money markets, "The industry may have won a battle, but the war isn't over," concedes Niels Holch of advocacy group the Coalition of Mutual Fund Investors in an email to TheStreet. Now the Federal Reserve's Financial Stability Oversight Council will have the ability to peer into money markets and propose new regulations. "Ironically, the industry may face even more draconian solutions proposed by these agencies," says Holch.

And there is reason to believe that in the case of money markets, the opacity of markets doesn't preclude change. "[My] guess is that investors would not have fled [money market] funds, but that fund groups would have been squeezed -- maybe imposing fees/conditions driving investors away," wrote Alan R. Palmiter, a professor at Wake Forest's School of Law and mutual fund expert, in an email to TheStreet. Though he added of the stalled SEC deliberations: "Somebody's gotta fund insurance and the industry says the returns are too low for investors to do it and the margins too thin for the fund groups. Check, checkmate."

With stock trading venues, the Federal Reserve could also use its newly expanded Dodd-Frank reform powers to increase its oversight of high-frequency trading and dark pools.

For Schapiro, whose reform efforts have gone dark, using recent failures as a motivation to dig deeper may be the only way to find a light at the end of the tunnel.

For more on money market fund risks, see why the Federal Reserve's recent liquidation of bailout-era funds means AIG's (AIG - Get Report) toxic debts may be headed to a fund near you. See why 'dark pools' want faster, cheaper and dumber money to hit their order books for more on nonosecond-fast stock trading and flash crashes.

-- Written by Antoine Gara in New York
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