Updated at 11:05 p.m. EDT on May 9 to reflect Terra Nova's statement and latest details.
NEW YORK (
) -- The unusual trading action in
Procter & Gamble
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
, a Chicago-based provider of prime brokerage and clearing services, a person familiar with the situation told
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.
"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
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,
Nasdaq OMX Group
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
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
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
. 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.
Terra Nova is apparently already under scrutiny for allegedly lax trading policies and procedures. The company, which is listed on the over-the-counter Bulletin Board under the symbol "TNFG.OB," disclosed in its Form 10-K for fiscal 2009 filed on March 30 that it received a Wells Notice on March 9 from FINRA, alerting the company of a recommendation for disciplinary action against it related to short sales occurring in the October-December 2007 timeframe.
FINRA is alleging that Terra Nova "accepted short sale orders without proper arrangements to borrow the securities" during that period, a practice known as "naked" shorting.
Also in the Form 10-K, Terra Nova disclosed its receipt of a Wells Notice in December 2009 from NYSE Regulation, saying the NYSE is investigating its conduct in four separate matters. The most recent of these is an allegation from September 2008 that a "large volume of erroneous trades" were placed by a Terra Nova client named Hsu-Tung Lee through an automated trading program.
"NYSE alleges that these trades far exceeded Lee's buying power, disrupted the market and indicate that Terra Nova failed to establish or maintain appropriate policies or procedures to prevent such erroneous orders from reaching the market," the filing states.
The other allegations, one of which dates back to January 2005, stem from similar alleged deficiencies in the firm's control policies and procedures related to short sale orders, restrictions on "wash sales and prearranged trades," and possible "spoofing" of the market by a customer who allegedly entered and then cancelled orders prior to the market's open for a two-month period in 2008.
Terra Nova said in its Form 10-K that it would "vigorously defend" itself against the allegations brought by FINRA and the NYSE.
Written by Michael Baron in New York