More share trading is increasingly shifting away from traditional public stock exchanges into venues known as dark pools. These are private, electronic markets where investors can buy and sell shares without displaying their orders publicly. While this anonymity can reduce trading costs, it also removes information from the wider market, limiting what other investors can see about supply, demand, and price formation.

As dark pools have grown in use, a recent study from the University of Missouri suggests they may be weakening transparency in public equity markets. The research indicates that higher levels of dark pool trading are associated with a greater risk of sudden stock price crashes. By diverting trading activity away from visible exchanges, dark pools may reduce the flow of information that normally helps prices adjust gradually rather than abruptly.

Dark pools operate by matching buy and sell orders electronically without public disclosure and typically offer narrower bid–ask spreads. These lower transaction costs tend to attract less-informed investors, who trade mainly for liquidity reasons rather than to exploit new information. According to Ken Shaw, a professor of accounting and one of the study’s authors, this small but consistent price advantage provides a strong incentive for such traders to use dark pools, particularly when they are not focused on discovering new information or ensuring immediate execution.

In contrast, informed traders—those who invest time and resources in uncovering firm-specific information—are more likely to trade on public exchanges. Because execution in dark pools is uncertain and depends on matching orders, informed traders face higher risks there. They therefore favour exchanges such as the New York Stock Exchange and NASDAQ, where execution is more reliable and information advantages can be monetised quickly. However, as uninformed traders migrate away, trading on public exchanges becomes more expensive overall.

This separation of traders has important consequences for corporate disclosure. In public markets, informed traders play a disciplining role by scrutinising firms and pressuring managers to release both positive and negative information. Shaw explains that when informed trading becomes costlier, this pressure weakens. Managers then face fewer incentives to disclose bad news promptly, allowing negative information to be withheld or accumulated over longer periods.

The study also finds a link between dark pool activity and accounting behaviour. Firms with substantial dark pool trading were more likely to make unusual accounting adjustments before experiencing a stock price crash. These practices can temporarily mask poor performance and delay the release of bad news, increasing the likelihood of a sharp correction when the truth eventually emerges. Using data from FINRA between 2014 and 2023, the researchers highlight growing concerns—also raised by the Securities and Exchange Commission—that anonymous trading venues may be reshaping incentives in ways that heighten market instability rather than reduce it.

More information: Bidisha Chakrabarty et al, Crashing in the Dark? Dark Trading and Stock Price Crashes, Journal of Business Finance & Accounting. DOI: 10.1111/jbfa.70016

Journal information: Journal of Business Finance & Accounting Provided by University of Missouri-Columbia