Crashing in the Dark? Dark Trading and Stock Price Crashes

ABSTRACT Equity trading volume is increasingly moving from stock exchanges to off‐exchange dark venues. Theory provides opposing predictions about the association between dark trading and stock price crash risk. Arbitrage cost arguments predict a positive relation, whereas the price efficiency theory predicts a negative relation. Our results support the former: Dark trading significantly increases stock price crash risk. This result is economically meaningful and robust to using an exogenous shock to dark trading to address endogeneity concerns. Further, in the weeks of and after a stock price crash, abnormal trading volume and trade size increase on dark venues, and this effect is greater for stocks with higher institutional ownership and worse earnings news in the crash week. In sum, this study introduces a novel feature, extreme negative stock returns from dark pool trading, and also contributes to a nascent literature on the consequences of stock price crashes. Our results also have potential regulatory implications: By facilitating the separation of informed and uninformed traders, dark markets incentivize managerial withholding of bad news, which increases stock price crash risk.