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TheStreet Open House

Market Access Loophole May Hold Key to Crash

Updated to add statement from SEC about meeting in Washington D.C.

NEW YORK ( TheStreet) -- Three full days have passed since the market's meltdown on May 6 and there is still no official word about what triggered the unusual trading action.

The delay is thought to stem from the size and complexity of the computer systems and trading technologies involved. It's unclear when or even if a definitive answer will be reached by the regulators and exchanges investigating the volatility.

A meeting held Monday in Washington, D.C. between Securities and Exchange Commission Chairman Mary Schapiro, officials from Financial Industry Regulatory Authority, and executives from six exchanges to discuss the unusual trading action on last Thursday was described as "constructive" in a brief statement issued by the SEC but it yielded very little additional information.

"As a first step, the parties agreed on a structural framework, to be refined over the next day, for strengthening circuit breakers and handling erroneous trades," the SEC said. The exchanges involved in the meeting were the New York Stock Exchange, which is operated by NYSE Euronext (NYX), the Nasdaq Stock Market, which is operated by Nasdaq OMX Group (NYX), BATS Global Markets, Direct Edge, the International Securities Exchange, a U.S. options exchange owned by Eurex, and the Chicago Board of Options Exchange, a unit of CBOE Holdings.

Sponsored direct market access may become the focus as investigators dig deeper into the trading action. Often referred to as "naked" or "unfiltered" access, these arrangements allow regulated broker-dealers to lease out their access to the exchanges to unregulated clients. This system has been under scrutiny for months by the SEC, which started the process of effectively prohibiting the arrangements in January because of the potential for erroneous trades.

Sponsored direct market access may been a factor in the unusual trading in shares of Procter & Gamble (PG - Get Report) that appear to have played a role in the stock market crash on May 6, according to a person familiar with the situation who declined to be identified.

The scenario outlined for TheStreet is that a large sell order in P&G stock came into the NYSE through a channel associated with Chicago-based broker-dealer, Terra Nova Financial (TNFG), according to the person, who spoke under the condition of anonymity. The order is thought to have moved through Terra Nova's direct "pipe" to NYSE Arca from a customer using Terra Nova's sponsored direct market access solutions.

Terra Nova issued a statement late Sunday saying it's "not aware of any link between Terra Nova and the unusual trading activity." There is no indication of wrongdoing on Terra Nova's part at this time.

A P&G sell order, believed to be erroneous, appears to have contributed to the market action between 2:40 p.m. EDT and 3:00 p.m. EDT on Thursday. During this period, the Dow lost roughly 600 points, and P&G shares dropped more than 30%. NYSE Euronext and Nasdaq OMX Group have said they are canceling trades in hundreds of stocks. P&G itself has called the trading on its stock on Thursday an "aberration." Other stocks seeing dramatic price swings on Thursday included 3M (MMM) and Accenture (ACN).

The investigation into what happened Thursday is ongoing and very much in flux. In a joint statement Friday, the SEC and the Commodities and Futures Trading Commission said they are continuing to review the unusual activity. They have indicated they are looking at how "disparate trading conventions and rules across various markets may have contributed to the spike in volatility."

This refers to different rules about stopping or slowing trading at various exchanges. NYSE officials have said the exchange's liquidity replenishment point, or LRP, mechanism kicked in on many stocks on Friday, bringing human specialists into the mix and slowing trading. But due to the National Market System's trade-through rule, which allows all orders to be visible to all market makers and trading venues, trading continues elsewhere in situations such as these, which appears to have happened in this case.

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