“The Securities and Exchange Commission, in a confidential report, blasted the New York Stock Exchange for failing to police its elite floor-trading firms and for ignoring blatant violations in which investors were shortchanged by millions of dollars in trades involving more than two billion shares over the past three years,” writes Deborah Solomon in today’s Wall Street Journal.

“The 40-page report, dated Oct. 10 and reviewed by The Wall Street Journal, is a severe rebuke of both the floor-trading firms, known as ‘specialists,’ and the self-regulatory structure that monitors the Big Board floor. It paints a picture of a floor-trading system riddled with abuses, with firms routinely placing their own trades ahead of those by customers — and an in-house regulator either ill-equipped or too worried about increasing its workload to care. And it concludes that when the NYSE does act on investor abuses, the exchange often does little more than admonish the specialists in a letter or slap them on the wrist with a light fine.”

“The SEC staff ‘is concerned that the NYSE’s disciplinary program is viewed by specialists and specialist firms as a minor cost of doing business, and that it does not adequately discipline or deter violative conduct,’ the report says. It adds that the floor-trading firms “have no meaningful compliance programs for reviewing their specialists” compliance’ to various trading rules.”

“The SEC report says that about 2.2 billion shares were improperly traded over the past three years, costing investors $155 million. In the context of overall Big Board trading activity, the improper transactions cited by the SEC involved less than 1% of the shares traded during the period — equivalent to about 1½ days’ typical trading volume.”

“The report cuts to the heart of public trust in the 211-year-old exchange — the world’s biggest, and one of the last that still matches buyers and sellers with human traders. And it comes as the Big Board is reeling over the pay-related ouster of Chairman Dick Grasso and is being criticized for how it conducts business.”

“The findings are likely to bolster those who argue that the NYSE’s regulatory arm should be taken out from under the exchange’s control. And it is sure to raise further questions by investors over whether the specialist system should be scrapped in favor of an electronic-trading model embraced by most other exchanges. Fidelity Investments and some other institutional investors have called for an end to specialists, which are charged with assuring that trading is orderly for specific stocks. This week, the NYSE’s interim chairman, John Reed, will propose major changes in the exchange’s governance, including an overhaul of the NYSE’s board, in a bid to reduce conflicts of interest.”

“The NYSE, which was given 15 days to respond to the report, declined to comment on it or to say whether it had responded to the SEC. The Big Board also said it would be inappropriate to speak about a confidential SEC inspection report ‘that was provided to The Wall Street Journal by someone who acted unethically.’ The SEC also criticized the Journal for publishing the report.”

“SEC Chairman William Donaldson, who headed the Big Board in the early 1990s, has been critical of the exchange’s governance over the past several months, saying he wants to see some separation of the NYSE’s regulatory and business operations. However, Mr. Donaldson hasn’t called for a complete split of the regulatory and market operations and has suggested that the NYSE’s specialist system should continue to operate alongside newer, electronic marketplaces.”