(FORTUNE Magazine) – For 132 years the New York Stock Exchange has extolled its specialist system as the keystone of its stature as the world's greatest marketplace for trading stocks. The folks in the black and colored jackets who deftly referee the melee of frantic buyers and sellers on the exchange floor are as much a symbol of unfettered capitalism as the NYSE's monumental Greco-Roman facade. What's not to like about a bunch of regular blue-collar guys who, when they depart the temple at Wall and Broad each evening, meet for beers at Harry's bar?

But suddenly the specialists' role as capitalism's noble traffic cops is under siege, and the attack threatens to pull down the temple itself. SEC chairman William Donaldson and congressional lawmakers are "assessing" whether the NYSE's rules allow human market makers to impose many billions of dollars a year in extra costs on investors--first, by grabbing markups for themselves at customers' expense; second, by forcing them to pay excessive commissions to the floor brokers who work for Wall Street firms; and ultimately by skewing the stock prices that investors pay. What has finally pushed regulators to the brink of action, after years of ignoring such complaints, is the swelling rage of the NYSE's most powerful customers--institutional traders like mutual funds and state pension funds. Seizing on what appear to be deep fissures in the once-untouchable institution and the spate of scandals that have put the Big Board on the defensive, the traditionally whisper-shy funds are now screaming for radical change.

Even the NYSE admits that the specialists have at times abused their position as middlemen to fleece customers. The Big Board--pushed hard by the SEC--is in the midst of an investigation that has so far unearthed evidence that specialists sometimes sold investors stock from their own inventories at inflated prices when the clients could have bought it cheaper directly from another seller. The NYSE reportedly wants the specialists to pay the biggest settlement in the exchange's history, more than $150 million in restitution and fines. The SEC says it might stiffen the penalties if the NYSE is too soft.

But the biggest problem, the funds contend, isn't the headline-grabbing abuse but rather an outmoded regulation that lies at the heart of the system: the trade-through rule. Instead of instantaneous, computer-to-computer transactions on electronic networks known as ECNs, the trade-through rule forces investors into a slow-grinding system that freezes their buy and sell orders for up to half a minute--an eternity by today's trading clock. American Century, the big mutual fund company, is calling for an end to that rule, which essentially protects specialists from outside competition. Other fervent critics include Steve Westly, the California state controller who oversees $115 billion in pension fund assets, and Vanguard founder John Bogle. Says Bogle: "The specialist system is a dinosaur that maintains as much of a monopoly as you can get in this world."

The biggest surprise has been the broadside from Fidelity Investments. America's largest mutual fund company depends heavily on the NYSE: Fidelity accounts for as much as 5% of the exchange's daily trading. It also likes to keep a low profile. In the past the Boston behemoth has offered only muted criticism of specialists, who shepherd tens of thousands of Fidelity trades every day. No more: "The specialists are a combination of toll takers and speed bumps for the capital markets," says Scott DeSano, who heads the fund giant's equity-trading department. "Our gripe isn't with the specialists themselves but with the monopoly privileges that allow them to operate to the detriment of all investors."

What set this tempest in motion, no surprise, is l'affaire Grasso. Certainly the revelations about the former NYSE chairman's outlandish pay package and the board's lack of oversight tarnished the exchange's sterling reputation. But Dick Grasso's departure may have actually contributed to the NYSE's current predicament. That's because over the years Grasso had been the most adroit defender of the specialist system--especially during the tech boom of the mid to late 1990s when the rival Nasdaq was in full glory and NYSE-listed companies were pressured to jump ship. Then came Sept. 11, when Grasso and his human market makers seemed to save the day, restoring trading to the exchange's blue-chip roster of stocks in a mere six days--a feat that became the stuff of legend. And then, when the tech bubble burst, it looked as if the old-fashioned NYSE was a bulwark of financial stability and trustworthiness. The specialist system, despite its backward ways, seemed to make sense.

"The NYSE has been obsolete for 20 years, yet Grasso managed to gain market share," marvels David Whitcomb, chairman of Automated Trading Desk, a pioneering electronic trading system. Indeed, the NYSE still trades an astounding 80% of the volume in its listed stocks.

But that 80% is at the heart of the problem. Critics contend that the NYSE holds that dominant position in the global marketplace not because of the superiority of its service but because of the coercive power of the trade-through rule.

Here's how it works: At the NYSE most trades must go through human hands, and those hands belong to the specialists. The Big Board assigns every one of its 2,800 listed stocks to a single specialist; on average, the 500-odd specialists manage the trading in about five stocks each. They work for seven firms that own about one-third of the NYSE's 1,366 seats; the biggest are LaBranche & Co.; Spear Leeds & Kellogg, a subsidiary of Goldman Sachs; and Fleet Specialist. Their role is ostensibly to benefit investors by maintaining a "fair and orderly" market. That means that if a stock is falling rapidly and no one else wants it, the specialist is obligated to act as the buyer of last resort, stepping in to cushion the fall until the buyers return.

In theory, their market making smoothes trading by reducing volatility. But the specialists' profit motive is at war with that theory, because every time they buy stocks in a steeply falling market, they empty their own pockets. "If they followed their own rules, you'd think they'd lose money all the time," says Dale Oesterle, a professor at Ohio State. So what happens? Many customers, including Hank Greenberg, CEO of insurer AIG (who recently penned an op-ed piece in the Financial Times), charge that they don't step up. On the contrary, the specialists' niche is fabulously profitable. According to an October 2003 study by Brian Becker of Precision Economics, a Washington, D.C., research boutique, specialist firms posted pretax margins of 37% to 61% last year, vs 9.7% for the big Wall Street firms.

The specialists get those fat margins, remarkably, by exploiting a mechanism that's supposed to benefit their customers. It's called "price improvement": finding quotes for their customers superior to the ones posted on any exchange, even their own. The specialists mine those hidden deals by holding auctions on the NYSE floor. When a block of stock in a given company--call it XYZ Corp.--is offered for sale, a bunch of floor brokers, who usually work for Wall Street firms and represent institutional investors, gather around the XYZ specialist's post and bid for the shares. The auction--it has moved from open outcry bids (i.e., yelling) to ones on handheld computers--supposedly elicits the world's best prices.

Now imagine that there are both a would-be buyer and a seller for XYZ shares who place limit orders (those set to a specific price) at $10 apiece. Both orders arrive through the Big Board's SuperDot electronic order-routing system. SuperDot, by the way, is superslow: It takes the specialist as long as ten seconds to post the quote on his screen for the floor brokers to see. But then, instead of the specialist's simply matching the two orders and getting out of the way, an elaborate dance often ensues.

If the seller, whose quote is known as the "ask," or "offer," arrives after the "bid" is made, the specialist is encouraged to "price improve" the seller's offer--by paying, say, $10.02, for the shares. In this case, the seller makes a small premium. The would-be buyer is less happy. His order sits there until someone is willing to sell at his price or until he cancels it himself, which takes an average of several seconds and as long as 30 seconds. As new sellers arrive, the specialist can keep price-improving the last offer, grabbing the shares that our buyer wants. True, the specialist is paying more for the shares--a boon to the sellers--but that's not the whole story. The buyer can't bid against the specialist because it takes him too long to cancel his initial order and enter a more competitive one. He's trapped, in other words. After several seconds have passed, the best offer for XYZ shares could have risen to $10.16.

This hypothetical run-up in the market price for our fictional XYZ shares isn't as rare as you might think. And that has to do with yet another advantage the specialist holds. Only he sees all the orders in his "book" on a real-time basis. "The specialist has all the information on the way the stock is going to move, and we don't," says Fidelity's DeSano. If the orders point to a rush of interest for XYZ, it's in the specialist's advantage to price-improve the seller. But that prevents the would-be buyer from securing his order before the price moves up.

So, getting back to our example: The buyer, a long-term investor eager to add XYZ shares to his portfolio, swallows his frustration and sends in a new bid at $10.16. The specialist finally sells him the shares he bought moments ago--this time with a twist: It's the buyer who gets his price "improved," landing the shares at $10.15 each. What a deal!

Given this maddening runaround, why don't institutional traders flock to the ECNs--platforms such as Instinet, Archipelago, or Island that let anyone trade any stock in milliseconds for a firm, posted bid or ask? They do, in fact, for the 3,340 Nasdaq composite stocks and countless unlisted companies. But in practice they often can't use ECNs to buy the 2,800 NYSE stocks, which just happen to be most of the biggest and best-known companies in the world. Why? Because, again, the SEC's trade-through rule demands that if the best price is posted on any official exchange--which in the vast majority of cases ends up being the NYSE--the customer's order must be routed there. That rule holds even though prices on the Big Board are not guaranteed and those on the ECNs are. John Wheeler, head of trading at American Century, calls it a "maybe price."

In a nutshell, the trade-through rule prevents funds from choosing less risk over a possibly better price--and nail-biting uncertainty--on the NYSE. It's as if you have two offers for your house, one for $500,000 all in cash, and one for $510,000 subject to the buyer's obtaining a mortgage, but the law bars you from taking the all-cash offer.

Sending in orders for NYSE-listed stocks electronically is so clunky and infuriating that most institutional investors try to get an edge by going through floor brokers. Those Big Board denizens, who typically work for Wall Street firms that own seats on the exchange, can jump in front of SuperDot orders and grab the shares for their clients. And forget the specialists' markups--this is where fund companies (translation: the ordinary investors who pay their fees) really get slammed. Depending on floor brokers has two costs. The first is commissions, which average around 5 cents a share, compared with 2 cents for ECNs. American Century, for example, spends $150 million a year on commissions --$125 million more than if all its trading were electronic.

The second cost is potentially larger and more shadowy. Buyers and sellers sacrifice their anonymity by divulging their orders to the Wall Street middlemen. Most securities firms zealously try to protect that information. But Wall Street is famously a sieve--information leaks out from everywhere. And those whispers can dramatically move the price of the shares that the fund is in the process of accumulating. "When we're bulking up on a new stock," says American Century's Wheeler, "and we give the buy ticket to a bulge-bracket firm, they can trade ahead of us on a proprietary basis after they execute the first order. We might as well write them a check."

Yes, membership has its privileges. That's why seats on the exchange, even during the present crisis, sell for well over $1 million.

The solution to this madness, say customers, is to kill the trade-through rule and make all parties post all their prices electronically. The result would be an instantaneous public competition for bids and asks. Traders would shoot at one another's prices, which they'd view in real time on their computer screens, with rapid-fire counterbidding. The spreads the specialists now feast on would narrow radically, just as they have for Nasdaq stocks. Buyers could purchase for a couple of cents less; sellers could get a penny or two more. It may not sound like much, but it adds up to billions of dollars a year in investor savings.

Eliminating the trade-through rule would be an enormous blow to firms like Merrill Lynch and Goldman Sachs. Commissions aren't quite as lucrative for Wall Street houses as they used to be, but those fees pay the bills when the really profitable businesses--floating IPOs and secondary offerings--are in a slump, as they have been for the past couple of years. And the specialists, who own many of the seats on the exchange, don't want any substantive change at all. So it's no surprise that the official NYSE position is to leave unwell enough alone. "The ECNs want to change the rules to benefit their market model because they can't compete," says Bob McSweeney, a NYSE senior VP.

But the tide may have finally turned. Even McSweeney acknowledges that the trade-through provision is "seriously threatened." Eliminating the monopolistic rule wouldn't shut down the venerable exchange. With its great brand name, history--oh, and most of the nation's blue-chip companies--it could thrive as a marketplace. The future of the market makers in the thin cotton jackets would depend on whether customers, unshackled and free to choose, thought they truly added value. You may not want to be on the specialists' side of that trade.