Pershing Square has filed an updated 13D disclosing that they sold 5 million shares of Valeant last week. Pershing almost surely considered this sale to be sensitive information, but I believe that their execution method was quite conspicuous.



In a recent blog post, I noted that some institutional flows may leave a signature in FINRA ATS data. IEX in particular seemed to have some enthusiastic customers, some of which were also their shareholders. [1] In addition to the FINRA data, IEX reports near-realtime volume data on their website, which could make customer flows detectable long before transactions are complete. [2] I noted that the last time Pershing Square traded Valeant common stock, IEX reported an anomalously high market share of Valeant trades that day:

[I]t may be more than coincidence that IEX’s share of VRX volume was anomolously high when Pershing Square recently bought 2 million shares. It’s (almost) too easy to mention the irony if valued information has leaked because of Greenlight’s or Pershing Square’s support for IEX. Ackman’s paranoia about front-running features prominently in “Flash Boys.”

So, when IEX abruptly began reporting very high market share in Valeant on Dec. 24, it piqued my interest. After a few more days of persistently high volume, it seemed very likely that Pershing Square was trading the stock. On the 30th, I tweeted “I hope Pershing Sq read my post,” along with some screenshots of Valeant volume on IEX.



Now, IEX has other loyal customers — it could have been that Greenlight was trading Valeant for instance. But this seemed less likely because of Pershing’s close relationship with the stock. Just looking by eye [3], when IEX showed a lot of activity on Valeant, the price seemed to either drift down or stay stable (sometimes appearing “pinned”) — and, when IEX showed a pause in activity, the price tended to rise. That kind of pattern may indicate that the IEX-favoring trader was selling. [4] Short-swing profit rules also mean that Pershing Square would have been more likely to be selling than buying (see Matt Levine’s footnote #5). Altogether, the information at the time was very suggestive that Pershing Square was selling Valeant common stock. [5]



Traders have always maintained relationships with their favorite brokers and market centers. Sometimes these relationships can result in suboptimal execution quality. But hopefully, in exchange for their loyalty, traders receive other benefits. Perhaps Pershing Square has decided that furthering IEX’s “pro-investor” agenda is worth leaking their trading intentions. Or, more cynically, perhaps they’ve decided that it’s more important to support their investment in IEX. Either way, if I were Pershing Square, I’d be giving those decisions another look. [6]



[1] IEX CEO Brad Katsuyama has disclosed that some customers heavily favor IEX (at around 15m:10s):

We have some very close partners that have shifted a lot of their trading towards IEX — a third of their volume is now executed on our market.



[2] IEX doesn’t report trades or volume in their current market data protocol. Perhaps that’s an indication that IEX thinks its trade data is sensitive? It wouldn’t be hard for a machine to read the data from the website though (a tool like PhantomJS might work). That data could probably be matched with off-exchange prints on the consolidated tape to get a more precise view of IEX trades. Regardless, if and when IEX becomes an exchange, its trades will be explicitly identified on the tape.



[3] This is far from rigorous, obviously. I’d love to see an analysis of price impact and IEX volume data with large sample size.



[4] Liquidity providers would obviously know whether their counterparties on IEX had a tendency to be buying or selling Valeant in a given minute/hour/day/week. I have never used information like this to make trading decisions (nor has my company), but I believe it’d be perfectly compliant to do so. Valeant volume (single-counted) on IEX was comparable to the volume Pershing Square reported for each day. So, if Pershing sent 1/3 of their volume to IEX (see [1]), that means that their order flow probably attracted liquidity onto IEX. A lot of that may have been due to execution algos noticing the flow and choosing to interact with it. If execution algos can use information from dark pool fills to make trading decisions, then surely prop traders can too. This is probably a much more important source of information leakage than the type that IEX claims to prevent.



[5] The larger picture could have been more complex, of course. Pershing could have been selling common stock, while simultaneously buying calls or selling puts.



[6] Some crude methods to estimate the potential benefit to Pershing Square of heavily patronizing IEX:

Probably around 5 million extra shares traded on IEX as a result of this (likely) routing decision. At 18mils/share, IEX would’ve made $9k extra revenue. Maybe there’s some momentum effect where, as IEX receives more volume, they attract future business. Let’s be generous then and say this volume is worth $100k to IEX and its project, and that Pershing Square believes any benefit to this project fully accrues to institutional traders like themselves. Alternatively, let’s assume that “success” for IEX means achieving the same market cap as Nasdaq, $10B. 5 million shares is about 0.2% of IEX’s monthly volume of 2-3B shares. Say that Pershing Square typically trades about once per month, so that they can increase IEX’s long-term revenue by 0.2%. Again, let’s be generous and say that 0.2% of revenue increases IEX’s chance of “success” by 1%. So, Pershing Square’s loyalty could improve IEX’s expected value by as much as $10M. It’s hard for me to parse IEX’s cap table in their exchange application, but let’s guess that Pershing Square owns 5% of it. That’d mean that Pershing Square would receive an expected-value benefit of $500k from their routing favoritism.

And estimating the cost to Pershing Square:

Say that Pershing’s intention to decrease their Valeant stake leaked before they finished their trading. By what amount would Valeant’s stock move? I don’t know, but a conservative estimate should be at least 1%, right? Given the explosion in volume on IEX, what probability would the market assign to the possibility that Pershing was selling? My personal estimate at the time was over 50%, with a <10% chance that they were buying (neither I nor my company used this information to trade). So, perhaps the stock would (and did) drop by 0.5% because of this leak. If Pershing had $300M left to trade, this one incident would cost them $1.5M. And it’s not hard to imagine this number being several times higher. Instead of Valeant, say that Pershing Square wants to trade a stock that nobody expects them to. Now, people looking at IEX’s reported volume wouldn’t have much idea of the side of the trade, or that it came from Pershing Square. But, the market-makers on IEX would probably know the side. The first hour after Pershing’s meta-order begins trading, maybe these HFTs develop an inkling (10% probability) that the meta-order is large (50% of ADV). Let’s assume, as IEX seems to, that HFTs are ruthless and that they start moving the price in accordance with the meta-order’s expected market impact. Using the square-root law (e.g. p8 ), the 50% of ADV meta-order could be expected to move the price by sqrt(0.5) * the stock’s daily volatility. Say the daily volatility is 1%, so the market impact would be around 0.7%. It’s already been an hour though, so perhaps half of this market impact has already occurred. The HFTs have 10% confidence that this further 0.35% move will happen, so they move the price by 0.03%. If Pershing had $300M left to trade at this point, that 0.03% would cost them about $100k. And maybe Pershing trades this size 5 times per year, so the routing preference could cost them $500k/yr. This is a paranoid (and rough) estimate of HFT order anticipation, but paranoia seems to be part of the IEX ethos.

In any case, it seems to me that the cost to Pershing Square of favoring IEX out-weighs a generously calculated benefit. But I guess a million here and there might not be a big deal to them.

