Imagine walking into a supermarket. You can see what’s on the shelves and how much everything costs. Now imagine walking into the same store with the lights off. You can’t see the prices or what’s available until after you’ve made your purchase.
That’s more or less how dark pools work in financial markets.
Dark pools are private trading platforms where prices and volumes stay hidden until after the trade is completed. They trace their origins back to the late 1970s, when regulatory changes first permitted off-exchange trading. The first dark pool, “After Hours Cross,” was then launched by Instinet in 1986. When large institutional investors place big orders on public markets, they risk moving the price before the trade is complete. That can drive up costs and reduce value for the people whose money they manage. Dark pools help reduce that price impact by allowing trades to happen anonymously, away from the central exchange. Thus, the availability of dark venues can be good news for long-term investors.
But there are trade-offs. As it grows, now accounting for over half of all stock trades in the US, up from just 16% in 2008, more and more of the market moves out of sight. This reduced transparency means price discovery increasingly happens behind closed doors rather than on public exchanges. While dark pools improve efficiency for large trades, they can also make it harder for anyone to understand what’s really driving market prices.
In a study published in the Journal of Corporate Finance, my co-authors and I examined the entire US market over 15 years. We found that despite concerns about the very high volumes in dark trading, it may actually help markets work better, especially when it comes to valuing companies and deciding how to pay their CEOs. Specifically, we found that when more of a company’s shares are traded in dark pools, that company is more likely to pay its CEO in shares or share options.
That might sound like a technical detail, but it matters. Paying a CEO in shares is one way to align their interests with those of shareholders – as a CEO, your pay rises when the share price increases. But you will only agree to this arrangement if you trust that the share price is telling the truth about your performance. And shareholders will only support it if they believe the price reflects real value, not just market noise. This is where dark trading helps by making prices more informative.
Our research also shows that this doesn’t work the same way for every company. First, the impact is strongest in firms where public information is limited or financial reports are complex – precisely where better price discovery matters most. In companies that are already very transparent and have plenty of available information, dark pools add little value because the stock price already does a good job of reflecting company value. But in less transparent firms, dark pools play a crucial role. When informed investors trade based on their insights in these venues, and those trades eventually show up in the stock price, that price becomes a more reliable measure of what the company is actually worth.
Second, this only works if someone on the board knows how to read the signals. We found the effect is strongest in companies where the compensation committee includes people with financial experience, who own shares in the company and who have the time to pay attention. Without that expertise, the link between dark trading and CEO pay disappears.
That should give us pause. In many countries, including the UK and the US, audit committees must include members with financial expertise. But there is no such requirement for the people who decide how top executives are paid, even when they are signing off multi-million-pound contracts.
This is not about whether CEOs are paid too much or too little. It is about making sure their rewards reflect what they actually deliver. When companies trade in markets that reflect real performance and when boards have the skill to understand those signals, everyone benefits.
Dark pools are not perfect. But they are part of how modern markets work. If we want executive pay to be fair and effective, we need to take that into account. And we need to make sure the people making these decisions are equipped to do it well.
Khaladdin Rzayev is our Senior Lecturer in Finance.