The visible impact of trading in the dark

Dark pools have a somewhat seedy image in the eyes of the public. They conjure up images of shady actors trading stocks anonymously without much regulatory oversight. Secret back room deals that put retail investors at a disadvantage.

Yet, this perception is false, in my view. Dark pools enhance liquidity and provide valuable information to investors and company executives alike. This is particularly true for less liquid stocks, where trading may be sporadic and large investors may be reluctant to trade shares in reaction to a company announcement because they fear they may move the share price by publicly disclosing that they are buying or selling large numbers of shares.

This enhanced liquidity available in dark pools means that share prices become a better reflection of the assessment of company news by the public. And company executives can get important information from this share price reaction.

Researchers from the University of Edinburgh documented that this feedback loop from prices to executives has important consequences for voluntary disclosure of company forecasts, M&A decisions and capital investments. In essence, through the enhanced liquidity in dark pools, corporate executives can better assess the reaction of investors to announcements and motivate them to change their behaviour.

For example, after a merger or acquisition is announced by a company, a negative reaction in the share price can sometimes convince corporate executives to step back and abandon the acquisition. If a stock is less liquid, a small number of trades can move the share price a lot, thus unnecessarily scaring executives. If there is additional liquidity in dark pools the share price reaction may be much more muted. Conversely, large investors may not sell any shares in illiquid stocks because they fear there isn’t enough liquidity to absorb the shares. With dark pools in place, they can sell more shares and thus signal to executives that their announced merger is probably not such a great idea.

The same goes for investment decisions. Higher liquidity through dark pools allows executives to get a better feel for the market reaction to corporate announcements and guidance on profits and investment decisions. Thus, managers are more likely to provide voluntary guidance on profits or may invest more if their stocks are traded in dark pools. And this effect is economically significant. If a company has the average volume of dark trading (c.23% of total volume), capital expenditures are boosted by 1.9 percentage points compared to a company with no dark pool trading. Given that the average capital expenditure of some 5% of total assets that is an increase of roughly one third. And as we know, increasing capital investments create jobs and increases share price returns in the long run.