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Market Access Loophole May Hold Key to Crash

The practice of broker-dealers offering customers the ability to place orders directly with exchanges may have contributed to the market's most volatile moments last week.

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



) -- 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


, the Nasdaq Stock Market, which is operated by

Nasdaq OMX Group


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, 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 Procter & Gamble Company 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


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


, 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


(MMM) - Get 3M Company Report



(ACN) - Get Accenture Plc Class A Report


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.

Asked about the role that sponsored direct market access arrangements may have played in the trading action on Thursday, Ray Pellecchia, a spokesperson for the New York Stock Exchange said Monday that "the trading activity of May 6 is under investigation, as announced by the SEC and CFTC."

"We can't discuss it at this time," Pellecchia said in an email.

Officials from the SEC, the Nasdaq, and the FINRA have yet to official statements with regard to sponsored direct market access and the role it may have played on Thursday.

The practice of sponsored direct market access allows broker-dealers to essentially lease out their credentials to non-broker-dealer customers. The SEC proposed Rule 15c3-5 on Jan. 13 in an effort to clamp down on the practice, and at that time it expressed concern that sponsored direct market access could lead to "erroneous orders as a result of computer malfunction or human error."

>>>View the SEC's Proposed Rule related to Sponsored Direct Market Access

The problem in nailing down a definitive answer to what caused the crash is that it remains unclear what sort of electronic trace an erroneous order leaves in the system after it is recalled. It is also unclear how broker-dealers manage the risk associated with granting clients direct access to the exchanges.

As the SEC notes in the text of its proposed rules on sponsored direct market access, "the customer's orders flow directly into the markets without first passing through the broker-dealer's systems."

Terra Nova already is under scrutiny for allegedly lax trading policies and procedures. The company disclosed in its Form 10-K for fiscal 2009 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 canceled 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.