Short selling and dark pool volume

Abstract

Purpose

Prior research posits that traders with short-lived information favor lit exchanges over dark pools due to execution certainty. This paper aims to focus on the relation between informed trading based on firm fundamentals and dark pool volume because the preferred venue for traders with longer-lived information is less certain.

Design/methodology/approach

The authors examine the effect of short interest, a proxy for informed traders with long-lived information, on dark pool volume using fixed effects, first difference and instrumental variable approaches. They examine the effect of dark pools on the profitability of long-lived information using market- and characteristic-adjusted returns.

Findings

The proportion of trading volume executed in dark pools is positively correlated with short interest. This result is stronger for stocks that suffer from greater uncertainty and stocks targeted by transient institutional investors. Short sellers profit substantially from their information as subsequent returns are lower for heavily shorted stocks with greater dark pool volume.

Research limitations/implications

In 2014, the Financial Industry Regulatory Authority began making trading data available for dark pools. Before that, only limited information was publicly available. The authors use that data to shed more light on dark pools activity.

Practical implications

The evidence presented in the paper helps inform the current discussion about the role and regulation of dark pools.

Originality/value

This is the first study to show that informed traders with long-lived information favor dark pools due to their opacity and the possibility of price improvement.

Citation

Boulton, T.J. and Braga-Alves, M.V. (2020), "Short selling and dark pool volume", Managerial Finance, Vol. 46 No. 10, pp. 1263-1282. https://doi.org/10.1108/MF-07-2019-0382