Casting a Light on Dark Venues

Increased trading in dark venues around earnings announcements offers advantages to businesses and markets that can allay regulators’ concerns

Peeyush TAORI

18 Jul 2023

Increased trading in dark venues around earnings announcements offers advantages to businesses and markets that can allay regulators’ concerns

When traders change their trading behaviour, it’s usually worth a closer look.

In recent years, trade in dark venues has increased. Also known as dark pools or alternative trading systems, dark venues are privately organized electronic trading platforms. They are often run by brokers and dealers who match buy and sell orders without the intermediation of market makers. Unlike public exchanges, or “lit” venues, trades on dark venues are not publicly displayed and information on orders is only shared after the trade has been executed and reported. Dark venues also differ from exchanges in that the majority of trades take place at the midpoint value.

A new study finds that trades in dark venues increase in the weeks around earnings announcements because there are good incentives for both businesses and traders to deal there. And in findings that may help alleviate some of regulators’ concerns, the choice of dark venues over lit venues has a measurable and positive impact on market quality and financial transparency.

Dark venues emerged in the 1980s following a new regulation by the Securities and Exchange Commission in the US (SEC). More competition and the growth in online trading led to an increase in their numbers. Over the last decade, the volume of trading on dark venues as a percentage of total trading has increased rapidly, reaching 14.6 percent in November 2019, up from just 5 percent in January 2008.

The pace of growth has brought more attention to dark venues and has led to regulatory concerns that dark venues could damage market quality and transparency. Now, the results of a new report – “Dark Market Share around Earnings Announcements and Speed of Resolution of Investor Disagreement” – may alleviate some of these concerns. The results show that the increased use of dark venues around earnings announcements encourages financial transparency and boosts market quality.

The Appeal of Dark Venues

Trading in dark venues offers important advantages to traders both large and small. While institutional investors trading in block trades made up the bulk of dark venue users when they first emerged, dark venues are now also used by other investors to carry out smaller trades.

When traders are making a trade that is large enough to move the market, choosing a dark venue means they can usually avoid price fluctuations. For example, if a seller is trying to sell a large number of shares of a security on a public exchange, news of the trade would likely cause the security to lose value before the seller can find buyers for all the shares. That is unlikely to happen on a non-public platform. The private nature of dark venues keeps trades and trading plans off public exchanges, making prices less volatile and allowing traders to maintain anonymity and keep their trading positions and strategies confidential.

As well as privacy, dark venues offer more attractive prices. Unlike exchanges where prices fluctuate, most trades in dark venues are executed at the midpoint price, giving traders a better price outcome.

Choosing a dark venue gives traders access to a platform where specialized traders and brokers congregate, increasing the likelihood of a trade. Trades are also typically completed faster on private platforms, which can give traders an edge in taking advantage of fast-moving market opportunities.

While dark venues are regulated, they sometimes operate under different and often more flexible regulatory frameworks than public exchanges. For example, unlike lit venues, dark venues are permitted to restrict access to certain traders such as institutional investors or high-frequency traders to protect traders from predatory trading.

Impact of Dark Venues

One of the key findings of the new study is that dark venues are more heavily used by traders in the weeks before, during and after earnings announcements. Earnings announcements are an obligatory, official public statement of a firm’s profitability for a quarter or a year. The announcements are made during earnings season and are important corporate news that can have powerful effects on pricing.

Earnings season sees heavy volumes of trades on trading platforms of all types, which is reflected in the report’s findings. During the week of announcements, trading volumes increased by 47.5 percent, and by 14.5 percent in the week following announcements. What is new here is that dark venues see even greater increases during this period, growing by 60.9 percent and 15.4 percent, respectively.

“These findings suggest that the net benefits to trading in dark venues increase during periods of significant news events relative to non-announcement periods,” say the authors. “Such large increases in net benefits translate into increases in dark market share, ie, the ratio of trading volume executed in dark venues divided by consolidated trading volume. In particular, during the announcement week, dark market share increases from the mean of 15.6 percent to 16.8 percent, which represents an 8 percent increase relative to the mean dark market share. These findings are consistent with dark venues becoming more attractive to at least some traders relative to lit exchanges around earnings releases.”

The study also found an important impact on financial transparency. During the busy earnings announcement period, businesses that produce a higher quality of accounting information are more heavily traded in dark venues than other businesses. The difference is the level of information asymmetry in the financial information. With asymmetric information, one party – usually the seller – has more information about the deal than the other party. This may be due to access to expert knowledge, or insider information, for example. When both parties in a trade have access to the same information, the risk is lower.

Regulators have concerns that dark venues may be an uneven trading field due to a lack of transparency in the financial information of the securities being traded. In what should be a welcome finding for regulators, the study shows that firms have good reason to strengthen rather than weaken their financial transparency.

Before, during and after earnings announcements, traders in dark venues show a preference for trading in firms with higher quality accounting, the study shows. Firms that offer more transparency in their financial information, then, increase their prospects of being able to complete the typically bigger trades that take place in dark venues. This knowledge this can incentivize firms to improve or maintain the quality of their accounting information to enhance their appeal to investors.

Market Quality

When news affecting the value of a company or its shares is released during earnings season, investors have different opinions about the impact of the news based on their own calculations and knowledge. Reaching agreement can take time. Once investor disagreements are finally resolved, prices are less likely to fluctuate.

The speed of resolving investor disagreements is an important aspect of informational efficiency. Achieving a consensus around asset valuation is also important for market stability and enabling informed decision-making, which are also concerns of regulators.

In the study, a higher share of dark venue trades at earnings announcements coincided with a faster pace of resolution of investor disagreements. This suggests that dark market share increases could lead to improved market quality. A one percentage point increase in dark market share resulted in a 6 to 8 percent increase in market quality. While singling out a particular reason for the faster speed of resolution is difficult, the researchers note that the findings certainly show the importance of traders’ choice of venue and the related impact on informational efficiency during a major news event, such as earnings announcements.

Dark Venue Opportunities

Dark venues offer traders a combination of better and steadier prices, anonymity and better execution outcomes in terms of price, speed, efficiency and costs during earnings announcements. These are strong incentives for traders, but dark venues also offer advantages for other market participants.

Resolving investor disagreements more quickly results in a more stable and efficient market for all participants.

Businesses can gain a better understanding of the factors that influence trades by studying the changes in market dynamics and fragmentation during earnings announcements. Understanding the role of dark venues can help firms adapt to market conditions more efficiently, particularly by presenting investors with transparent financial information and minimizing accounting asymmetries.

Finally, understanding how and why trading patterns and behaviours change during earnings announcements can help inform regulators of exchanges and securities as they seek to build frameworks for efficient markets and a level playing field.

About this Research

Karthik Balakrishnan, Xanthi Gkougkousi, Wayne R. Landsman and Peeyush Taori (2022). Dark Market Share around Earnings Announcements and Speed of Resolution of Investor Disagreement. The Accounting Review 97(5) :1-28

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Translation

Long held assumptions about the mutually incremental relationship between quantities and discounts have been upended by new research. The rule of thumb that the bigger the purchase quantity, the higher the discount is shown not to hold true for medium-sized customers buying products such as semiconductors, with implications for other products and industries.

Pile them high and sell them cheap. Buy more, save more. These slogans, and the thinking that lies behind them, have been accepted principles of product sales and marketing for generation.

The logic seems indisputable from the points of view of both the seller and manufacturer and that of the buyers. If a seller or manufacturer makes a large number of identical items and a single customer wants to buy a large part of this total production, then that buyer will receive the goods at a cheaper price than a buyer who wishes to buy a much smaller amount of the same product. The accepted theory has been that the seller is eager to dispose of his stock as quickly and as easily as possible, and so a big customer will get a better deal. By the same logic, it follows that customers who buy progressively smaller amounts of the same product will receive progressively smaller discounts.

However, the underlying premise behind these assumptions – that the bigger the purchase, the bigger the discount – has now been shown to be valid for only part of the story. In a new study by Wei ZHANG, Sriram DASU and Reza AHMADI entitled “Higher Prices for Larger Quantities? Nonmonotonic Price-Quantity Relations in B2B Markets,” published in 2017 by the Institute for Operational Research and the Management Sciences in Maryland, USA, the first part of the established belief holds true: the biggest customers do receive the biggest discounts. These customers remain the most valuable to a seller or manufacturer as they account for the bulk of sales. They are therefore typically able to use their size and bandwidth to exert pressure successfully on the seller to get a large discount.

The research focused on investigating the impact of a buyer’s purchase quantity on the discount offered. In this case, the seller was a microprocessor company selling semi-conductors, which are a short-life cycle product. The company negotiates with each of its buyers to set a price for the product. The buyers are mainly large electronic consumer goods manufacturers. In line with established beliefs, the research showed that the discounts received by smaller customers increased in line with the quantities they purchased, and the smaller the quantity they purchased, the smaller the discount they received.

What is unexpected is the experience of medium sized buyers. According to established logic, these customers would be expected to receive bigger discounts on their purchase price than smaller buyers. But this is not the case. In fact, the researchers found that as the quantities bought increase, the discount decreases, and then increases again for the biggest quantities.

“Contrary to our intuition, larger quantities can actually lead to higher prices,” say ZHANG, DASU and AHMADI.Thus, while previous beliefs of a bigger purchase quantity meaning a bigger discount would have resulted in a curve heading steadily north-eastwards, the results of ZHANG, DASU and AHMADI’s studies is an N-shaped curve. This unexpected result is rooted in the importance of capacity to the seller and its impact on the price negotiation process, explain ZHANG, DASU and AHMADI.

To understand the importance of capacity in price setting requires a switch in focus from the buyer’s mind-set to that of the seller. The seller or manufacturer is not concerned solely with getting the best possible price for the product, they also place a value on capacity.

‘’Large buyers accelerate the selling process and small buyers are helpful in consuming the residual capacity,” write ZHANG and his team. “However, satisfying midsized buyers may be costly because supplying these buyers can make it difficult to utilise the remaining capacity, which may be too much for small buyers but not enough for large buyers. Therefore, midsized buyers are charged a “premium.”

To get the best price for all his products, the seller needs to avoid transactions of a medium size and instead plan his sales based on a rationing decision. The rationing decision depends on the remaining capacity level, purchase quantity, demand distribution and the buyer’s profit margin before subtracting the cost of this product. The calculation can be done by following a dynamic capacity rationing formula devised by the researchers. The formula is based on the need for the seller to find a balance between controlling the capacity allocated to each buyer while still offering a capacity range that is acceptable to the buyer.

Ultimately, ZHANG & Co, say, “The seller should reserve capacity for buyers who are willing to pay more.”

The pertinence of the research is clearly of most use to firms manufacturing or selling semi-conductors. This is a highly competitive industry with several unique features and is characterised in particular by fast changing technological developments. In the semi-conductor industry, manufacturing costs are high and lead times are long and these factors lead to inflexible capacities. It is common practice in the industry for sellers to allocate capacity to different product lines based on demand forecasts and to start work on the related production several months ahead of the planned delivery date. Customers arrive sequentially and differ mainly in the quantities of product they order. Although products have a set price, the actual price paid is typically agreed after a process of negotiation, with big buyers usually driving a hard bargain. Because of the nature of the business, negotiation on prices is inevitable, explain the researchers.

“Buyers know that the marginal production cost of microprocessors is low and that sellers are eager to discount prices to fully utilise their capacities. Moreover, buyers can allocate their business among competing sellers.”

But while buyers may have an advantage when it comes to price, sellers often have an advantage when it comes to selling and controlling capacity. Buyers are free to meet their needs by buying from different semiconductor suppliers, but they tend to decide on suppliers early on in the purchasing process. This is because the technical features offered by different suppliers vary, and once selected, these features will impact the design of the buyers’ products and will be difficult and costly to change. That means that buyers tend to keep to their chosen supplier.

The lessons that can be drawn from the study may also be useful to some degree to other businesses and products. Inflexible capacities are also a feature of many businesses in the tourism industry, for example, although the researchers note there are different characteristics and constraints involved – for example, hotel rooms do not go out of date in the same way that semiconductor products become obsolete. Hotel rooms, airline and coach seats are all fixed number items that the seller or owner needs to sell in quantities to his best advantage. The main customers in these industries include bulk buyers such as travel agencies and resellers who want to buy in large quantities but who also want to negotiate the best prices. As in the semi conductor business, the individually agreed deals are closely interconnected, with the price and quantity agreed for one buyer impacting the price and quantity to be agreed for the remaining buyers. The researchers recommend that sellers develop a price-quantity analysis model that can help them optimise their prices. As with semi-conductors, the key point for the seller is the need to control the quantity being sold to each buyer before negotiating the price.

“Basically, given that each transaction has an impact on subsequent transaction, a good model of the price-quantity relation is necessary for the optimisation of the trade-off between the profit from the current buyers and that of future buyers,” they explain.

Contributing Reporter: Liana Cafolla

Source: Wei Zhang, Sriram Dasu, Reza Ahmadi (2017). Higher Prices for Larger Quantities? Nonmonotonic Price–Quantity Relations in B2B Markets. Management Science 63(7): 2108-2126.

https://pubsonline.informs.org/doi/10.1287/mnsc.2016.2454

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