VIDEO: Is the Market Rigged? The Debate Continues

I joined CNBC’s Bernie Lo and Susan Li and Traders Audio’s Ben Lichtenstein to weigh in on Michael Lewis’ allegations that the market is rigged.

Lewis, the best-selling author of Liar’s Poker and Moneyball released his latest book—Flash Boys—this week and generated a storm of controversy by alleging  high-frequency trading (“HFT”) rigs the markets against real investors—even professionals such as mutual fund and hedge fund managers.  (In one of his recent interviews, Lewis said that David Einhorn—considered one of the brightest hedge fund managers in the business—was like a “dumb tourist” in a fixed poker game full of sharks.)

The controversy centers around a particular type of legal front running that is made possible by HFT. For the uninitiated in securities regulation, “front running” is a situation in which a broker or advisor trades in front of their client.  What does that mean?  Picture it like this.  If I had a client who wanted to place a large multi-million share order to buy, say, Apple (AAPL), I could place a smaller order for myself immediately before I placed the client’s order.  If the client’s large order then moved the price by a few cents, I could quickly sell.  In effect, I’d be selling the shares to my own client at a risk-free profit.

There is one problem with this: It’s illegal, as it should be.  Brokers and advisors have a responsibility to look out for their clients’ best interests,  and front running clearly violates that standard.  But it is also a form of insider trading.  If I trade on non-public information—and knowledge of a large client order would quality here—I  would be breaking the law.

In the case of HFT, a trader is able to do a sophisticated version of this by playing on tiny timing differences between exchanges.  (For a detailed explanation, read Lewis’ book or this adaptation he published in the New York Times: The Wolf Hunters of Wall Street.)  It’s not technically illegal, or at least not yet. But it’s a loophole that certainly adds credence to the view that the markets are rigged to favor those with preferential access.

Ben Lichtenstein takes the other side of the argument, saying that there is nothing new under the sun.  There have always been traders willing to pay for informational advantages, and the markets today are far less crooked that they were a century ago—or even a decade ago.

On this point, I agree with Ben completely.  If you want to read a book about how truly awful it used to be, I recommend The Book of Daniel Drew.  Drew was such a notorious swindler that he actually changed the vocabulary of the financial markets:  He introduced the concept of “watering a stock.”

I do differ with Ben on one major point, however.  Ben argues that HFT adds liquidity to the market.  Liquidity is the grease that keeps the market’s wheels turning properly, and I agree that anything that adds liquidity to the markets is a positive that lowers trading costs and, ultimately, the cost of capital for the companies issuing stock.  Remember, the whole purpose of the stock market is to match investors looking for a return to companies looking to raise capital.

But does HFT really add liquidity? That’s debatable.  For a market to be deep and liquid, you need real buyers and sellers willing to engage in transactions.  But much HFT consists of “fake” orders that are made and immediately cancelled as a way of gleaning information about the size of the order book.  And when conditions get choppy, the high-frequency traders disappear completely, as we saw during the 2010 Flash Crash.

In any event, HFT has probably already seen its heyday.  As Michael Lewis noted, the IEX exchange, which is featured throughout Flash Boys, is designed to prevent high-frequency traders from having an unfair advantage.  Volume was already high, but following the publicity generated by Lewis’ book, I would expect IEX’s methods to become the new normal.  And in the interests of creating fairer markets, that’s a good thing.

Charles Lewis Sizemore, CFA, is the editor of Macro Trend Investor and chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays. .