The Invisible Hand in the Dark: The Disciplinary Effect of Dark Trading on Firm Investment

Abstract

We propose that the availability of dark trading for a stock provides stronger incentives for traders to acquire valuable information ex-ante, thereby restraining the manager from inefficient investment. Utilizing the trade-at-rule provision in the SEC’s Tick Size Pilot Program and a difference-in-differences design, we find that restrictions on dark trading lead to higher levels of investment and abnormal investment. The results are stronger for stocks with more short selling, an important type of informed trading and disciplinary force, before the Program. Our analysis also shows that this disciplinary effect mainly centers around empire-building and overinvestment tendencies. Such inefficient investment due to the restrictions on dark trading reduces firms’ future accounting performance. Overall, we identify a novel governance functionality of dark trading venues rooted in the mechanism of information gathering.

Keywords: dark trading venues, tick size pilot program, Informed trading, short selling, disciplinary effects, Investment