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Chicago Firm Linked to P&G Trade: Source

Updated at 11:05 p.m. EDT on May 9 to reflect Terra Nova's statement and latest details.

NEW YORK ( TheStreet) -- The unusual trading action in Procter & Gamble (PG - Get Report) stock believed to be at the center of the market's most volatile moments on Thursday is thought to have originated from Terra Nova Financial (TNFG), a Chicago-based provider of prime brokerage and clearing services, a person familiar with the situation told TheStreet.

Terra Nova issued a statement late Sunday saying it's "not aware of any link between Terra Nova and the unusual trading activity and wide market price changes" in P&G's stock. There is no indication of wrongdoing on Terra Nova's part at this time.

The exact circumstances of the trading action on Thursday are still unclear but sponsored direct market access -- the practice of broker-dealers essentially leasing their credentials out to non-broker-dealer customers so that they can trade directly with an exchange -- is believed to have played a central role. The Securities and Exchange Commission proposed a rule in January to effectively prohibit the practice, which is often referred to as "naked" or "unfiltered" access, and the potential for an erroneous trade to come through this way was addressed by the SEC when it proposed Rule 15c3-5 in January.

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"In particular, there is an increased likelihood that customers will enter erroneous orders as a result of computer malfunction or human error, fail to comply with various regulatory requirements, or breach a credit or capital limit," the SEC said rather ominously at the time. The comment period on Rule 15c3-5 ran through the end of March, but the agency has yet to formally adopt the rule.

Calls and e-mail inquiries to officials and press contacts at the SEC, FINRA, NYSE Euronext (NYX) and Nasdaq OMX Group (NDAQ - Get Report) had yet to be returned on Sunday.

Understanding the events that led up to Thursday's market collapse is complicated by this possible involvement of non-broker-dealers placing orders through these sponsored direct market access arrangements and the complexity of the underlying computer systems and networks processing trades. Terra Nova describes its sponsored direct market access solutions as allowing clients to "establish a direct connection between their proprietary platforms and the Nasdaq or NYSE Arca execution systems." Terra Nova's customers appear to be mostly hedge funds, but it also provides clearing services for other broker-dealers and registered investment advisers.

The scenario outlined for TheStreet by a person familiar with the situation is that the order in question -- characterized as a large sell order in P&G -- is thought to have come through Terra Nova's direct "pipe" to NYSE Arca, presumably from a customer using Terra Nova's sponsored direct market access solutions. In that case, Terra Nova would not necessarily have executed or cleared trades related to the order, which goes directly to the exchanges.

The pressure created by the entry of the sell order in question is believed to have then triggered P&G's liquidity replenishment point, a mechanism designed by NYSE to react to sudden volatility in a stock price. This slowed down trading and brought human specialists at the NYSE into the mix.

At the same time, the presence of the sell order was immediately registered electronically by other trading venues in accordance with the National Market System's trade-through rule that makes all bids and offers for stocks listed on various exchanges visible to all market makers. The machines then apparently took over, and the trades that did go through overwhelmed pricing in not only P&G but other issues, including many ETFs, as trading algorithms reacted to the price swings. The details of all this are still murky and are being sorted out by the exchanges.

The selloff in P&G, a Dow Jones Industrial Average component, was immediately flagged as unusual by market observers on Thursday. The stock fell more than 30% in moments, going from above $60 to below $40. The move exacerbated already intense selling on the major U.S. exchanges, driving the Dow down more than 600 points for a 1,000-point intraday drop at its session low in the 20-minute stretch spanning from 2:40 p.m. to 3:00 p.m. EDT.

The Dow recovered quickly, and closed down just 350 points, but there has been little concrete information about what happened in that 20-minute stretch. Both NYSE Euronext and the Nasdaq announced plans to cancel trades in hundreds of companies on Friday -- an acknowledgment that a mistake was made somewhere -- and officials from both companies have played the blame game.

The trades being cancelled by both the NYSE and Nasdaq are using price deviations of 60% or more as their benchmark for dismissal. P&G itself called the trading in its stock, which skipped to a low of $39.37 on Thursday, an "aberration" in a statement. The Nasdaq didn't list P&G among the companies whose stocks would have trades canceled, but the NYSE did.

Terra Nova said in its statement Sunday that it "thoroughly reviewed" its records and found that on May 6 it "cleared a nominal amount of shares (approximately 220,000) for the day's activity in PG shares and that those shares traded at or above $60 per share, and there was no unusual order or clearing activity." The company declined to comment further about whether it had been contacted by any regulatory authorities or exchanges about the trading action in P&G stock on May 6.

President Obama said Friday that regulatory authorities were still in the process of investigating what happened in the markets on Thursday, and the SEC and the Commodity Futures Trading Commission issued a joint statement on Friday as well, saying: "We are continuing to review the unusual trading activity that took place briefly yesterday Thursday afternoon to pinpoint its cause and contributing factors."

Adding to the depth of the broad market's plunge was that the mistake came at a particularly inopportune time. The debt problems of Greece had fed market fears of a spreading contagion across Europe all week, as evidenced by the recent rise of the CBOE Volatility Index, or VIX, since Monday, and stocks were already in broad decline. On Thursday, traders were already dealing with uncertainty about whether a bailout would come through for Greece, or even be enough, as well as apprehension ahead of Friday's jobs report, when P&G's drop hit the tape.

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