In the aftermath of Richard Grasso's resignation and accompanying scrutiny of the

New York Stock Exchange

, it's clear there will be changes at the Big Board. Beyond the makeup of its board of directors, the NYSE may ultimately be forced to amend its specialist system, which is currently being investigated by the

Securities and Exchange Commission

for alleged wrongdoing.

It's highly unlikely that the specialist system -- the basis for the NYSE's "open-outcry" auction trading -- will be mothballed, although some observers claim it's anachronistic and indefensible given modern technologies. "Why is the labor-intensive, specialist system still in place in this world of technology and innovation? Why aren't all trades executed electronically?" Doug Kass, general partner at Seabreeze Partners, recently mused on

StreetInsight.com

, a sister site of

RealMoney.com

. "You know the answer to these questions: The specialist system is enormously lucrative to its constituent members."

Also unlikely is that any tweaks to the specialist system would materially affect major Wall Street institutions, barring dramatic changes in the behavior of institutional buy-side firms. Why? Because they have made bets on both sides. Not only do the Street's big players have interests in specialist firms, they likely also own a piece of an electronic communications network, or ECN, the probable beneficiary of a change in trading practices.

As noted

here, many of Wall Street's largest brokerages acquired interests in specialists firms in recent years, including

Goldman Sachs

(GS) - Get Report

,

Bear Stearns

(BSC)

and

FleetBoston Financial

(FBF)

; the specialists owned by those firms are each among the NYSE's five largest.

Given NYSE specialist firms had after-tax profit margins of 24% in 2002, according to

The Wall Street Journal

, the Goldmans and Bear Stearns of the world have a vested interest in seeing the specialist system survive. By comparison, Goldman posted overall after-tax margins of 17.8% in its just-reported third quarter; the firm doesn't break out results for its Spear, Leeds & Kellogg specialist unit.

"What Grasso's pay brings to light is there's too much money being made by intermediaries," said Seth Merrin, CEO of Liquidnet, an electronic exchange designed to compete with the NYSE for institutional order flow. "Anytime there are so many intermediaries, it costs people money. There are too many hands in the pie, and in this age of technology there's no need for it."

While Grasso was a great champion of the specialist system -- one reason for his lavish compensation -- Goldman Chairman and NYSE Director Henry Paulson reportedly voted for Grasso's resignation. Notably, the heads of Bear Stearns, Fleet Specialist and

Van der Moolen Specialists

(VDM)

did not.

Putting aside any personal or public relations issues, which may have been paramount, why would Paulson be willing to risk life without Grasso? One reason is that few people can really envision any major disruption to the specialist system, which amounts to a near-monopoly in NYSE stocks. (While less than 20% of the volume of over-the-counter stocks is traded by the

Nasdaq Stock Market

, about 80% of the volume of Big Board names still trades via specialists.)

Another reason is that Goldman, among several other major brokerages, has hedged its bets.

Along with a host of other financial services firms, Goldman Sachs is an investor in Archipelago, one of the four original ECNs approved by the SEC in 1997. In the past year, Archipelago has migrated trading from the ECN to its "ArcaEx" exchange platform.

"There will always be a need for providers of liquidity and market makers regardless of how markets evolve," said a Goldman Sachs spokesman, who noted the firm also offers REDIplus, software that enables institutions to directly access ECNs. "Our strategy is to be a leading provider of liquidity in U.S. equity markets. We are agnostic in regard to the source of flow or means through which it is channeled."

All in the Family

What some people might call "prudent hedging" by Wall Street firms, others describe as "self-preservation," as did Steven Schonfeld, founder of Schonfeld Group, one of the largest U.S. proprietary equity trading firms. "Instead of assessing which

system provides the best execution, they want to cover each base. For a relatively minimal amount of money, they're in a 'win-win' no matter which execution venue comes to fruition."

Schonfeld's firm trades over 135 million shares daily and is one of the top users of the NYSE's DOT (designated order turnaround) system, which electronically routes orders directly to NYSE specialists rather than through a broker (thus eliminating one level of intermediary).

Unlike other proponents of electronic trading, he does not advocate the elimination of the specialists, arguing "you need humans for events when there's not liquidity."

Advocates of the specialist system often cite this "buyer of last resort" argument as the most compelling reason to maintain the status quo. However, some veteran participants recall specialists didn't act to stem the 1987 crash until Alan Greenspan assured Wall Street the

Federal Reserve

would back them up. Critics contend firms will be even less willing to risk their own capital today in the wake of industry consolidation and decimalization, which has crimped -- but not eliminated -- the specialists' profitability.

While not hoping for a test of the specialists' willingness to step into the breach, Schonfeld is willing to tolerate their role in the marketplace so they'll be there during "crazy markets."

However, the trader lamented the system's inherent conflicts. "Do they really care if the customer gets the best execution, or do they want to make more money?" he said. "Part of the reason specialists make money is they have an edge on execution vs. the customer. They could make money with a smaller edge."

One way to narrow the specialists' edge is for more "overlays" between the specialists and their customers "that will create liquidity and take the other side of trades," Schonfeld suggested. "Instead of orders coming and specialists matching

buyers and sellers, there should be more free range to go to other systems for matching."

For example, he noted

Instinet Group

(INET)

is going to allow DOT orders to search its Island ECN free of charge. If no match is made, the orders will be sent back to the DOT system. (An Instinet spokesman did not return calls seeking comment.)

"If many users do it, it'll change the dynamic and will help with execution on listed stocks," Schonfeld said. "If a lot

of institutions buy into that concept, it'll make

NYSE trading better," albeit still "far from ECNs in terms of providing the best execution."

The big "if" is whether enough institutions will employ Island for DOT trades, or other alternatives, to make a significant dent in the specialists' grip on Big Board names. This raises the broader question of why institutions aren't more eager to embrace electronic trading, an issue to be examined in a future column.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.