Self-regulation has failed at the New York Stock Exchange, and it's time to admit it. The recent inspection report by the Securities & Exchange Commission outlines a near-total regulatory breakdown at the NYSE. The Big Board's interim chief, John S. Reed, is proposing reforms that would allow the exchange to maintain control of its regulatory function. That option vanished when the SEC uncovered massive holes in the NYSE's self-regulation. The exchange now faces three choices: be regulated by the SEC, be regulated by an independent body spun off from the NYSE, or be regulated by the National Association of Securities Dealers (NASD), which oversees NASDAQ. It makes sense for America's two largest stock markets to be policed by the NASD unit playing the role of super-regulator.
The abuses described by the SEC go to the heart of the NYSE's specialist system. By trading ahead of customers, specialists were said to have siphoned off $155 million from investors over the past three years. Worse, the exchange didn't police its specialist firms, ignored repeated violations, and fined offenders so lightly that the penalties were seen as a minor cost of doing business. In the '90s, similar kinds of corruption led to the separation of regulatory operations from the NASDAQ market. Nothing short of that is needed at the NYSE.
Indeed, tight regulation may reveal that the specialist system is untenable and force the spread of electronic trading. So systemic is the corruption at the NYSE that it brings into question whether specialist firms could ever be profitable without it. It's time to find out.