Was the massive, 20-minute free fall last week the result of a hedge fund (hedge fund news) interacting directly with market centers via a "sponsored access" arrangement? Regulators are taking a close look, and you can bet sponsored access (sponsored access news) will be a big part of their inquiry. We will hear a lot about this.

TheStreet.com raises an interesting possibility. It notes "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." This could have been a big hedge fund, or some other non-broker dealer. It's unclear if any risk checks were performed on the order. It may well have been a "naked access" arrangement, which has many people concerned. It's also unclear if the order was fat-fingered or not.

In any case, the stock fell more than 30 percent quickly. That triggered a liquidity replenishment point, which slowed trading in the stock and shunted volume to other electronic execution venues. The selling pressure thus spilled into a system with no mechanism to slow down trading. The big drop in P&G affected indexes and various algorithms reacted to the drop, creating the massive selling pressure that whipped through the national market system.

And that sent the entire system into a temporary free fall.

Terra Nova issued a statement in which it strongly denied TheStreet.com's report. It said it "is not aware of any link between Terra Nova and the unusual trading activity and wide market price changes in the PG stock." In went further and said that it "cleared a nominal amount of shares (approximately 220,000) of the days activity in PG shares and that those shares traded at or above $60 per share, and there was no additional unusual order or clearing activity. Of that total, Terra Nova executed trades for 1,050 shares of PG at or above $60 per share."

However, it's unclear if trades by sponsored entities would be included in those figures, as those trades go directly to markets.

This theory has been making the rounds, but it certainly has not been accepted as fact. Indeed, many are starting to pooh-pooh the idea. The real culprit may have been a sudden, mysterious drop in of the e-Mini. That created selling pressure for all stocks in the index. One could argue that a combination of events led to the sell-off, a perfect storm perhaps.

But it seem clear that the electronically linked national market system has been exposed. While it has enabled trading at phenomenal speeds, it doesn't seem to offer the sort of interconnected protections that would have been useful. Only the NYSE provides circuit breakers for individual stocks, which served to push the selling elsewhere in the system. The mismatch between the exchanges and other execution points will likely be addressed quickly. In this process, some regulators may raise sponsored access as a related issue. Recall that the Securities and Exchange Commission (SEC news) proposed a rule in January to prohibit "naked access." - Jim