An analysis of potential Treasury auction techniques

Federal Reserve Bulletin, June, 1992 by Vincent Reinhart

Last summer's revelation of abuses of the rules governing the primary market for government securities spurred a comprehensive review of all aspects of market activity. Some of that work appeared in the Joint Report on the Government Securities Market, which the U.S. Department of the Treasury, the U.S. Securities and Exchange Commission, and the Board of Governors of the Federal Reserve System transmitted to the Congress in January 1992. While the Joint Report addressed many issues, its advocacy of experimentation with alternative auction designs for selling Treasury securities in particular attracted considerable attention. This attention likely owed to the sizable stakes. With the outstanding federal debt totaling $2.8 trillion and mounting with each year's fiscal deficit, the gain to the Treasury from even a modest improvement in selling technique could be substantial. In fiscal year 1991, for example, gross issuance by the federal government exceeded $1.7 trillion. Given that scale of borrowing, a reduction of one basis point in the average annual issuing rate at Treasury auctions would trim more than $200 million from the federal deficit each year. At the same time, the Treasury must maintain the integrity of the auction process by ensuring that no illicit activity is hidden by the sheer volume of transactions. A concern by investors that the market was not open and fair would be translated into lessened demands for Treasury debt and higher costs of borrowing.

By reviewing the academic literature on auctions, this article puts current Treasury practice and a popular proposal for reform in critical perspective. It also examines the alternative scheme embraced in the Joint Report that uses technology to give better protection against certain kinds of manipulative behavior and that has a potential for lowering borrowing costs.

BACKGROUND ON BIDDING

There is a large academic literature on auctions, with important early contributions by William Vickrey and Milton Friedman and significant later work by Paul Milgrom, among others (see the references at the end of the article). This research has classified the types of auctions, rigorously modeled the bidding strategies, and ranked auctions by various criteria regarding efficiency. Unfortunately, this literature has a language all its own that differs from the terms that the financial press uses. To avoid confusion, this article will use explicit, if somewhat unwieldy, names for each auction.

William Vickrey established the basic taxonomy of auctions by classifying them based on the order in which prices are quoted and the way in which bids are entered.| First, securities can be awarded at prices that are progressively lowered until the entire issue is sold; alternatively, the auctioneer can arrange the bids in ascending order by their price and decide on a single price that places the total issue. By the second measure, the auction can be a private affair with sealed bids opened by the auctioneer, or it can be conducted in real time, with participants in a single room or connected by phone bidding in public. This two-by-two classification yields four auction types: the first-price sealed-bid auction, the second-price sealed-bid auction, the descending-price open-outcry auction, and the ascending-price open-outcry auction.

Complicating matters, researchers after Vickrey further classified models by an assumption about the information that bidders have regarding the value of the auctioned object. One such model is the private-values case, in which bidders' valuations are subjective decisions, independent of each other. Another is the common-values case, in which each participant attempts to measure the value of the item by the same objective yardstick. The auction of a unique work of art not for resale is the prototypical private-values model, whereas a Treasury auction--with each bidder guessing at the security's value at the end of the day--is an example of a common-values model. This article concentrates on the common-values case, which is applicable to the sale of Treasury securities, and also assumes that agents care only about maximizing profit.

In general terms, the expected profit from winning an auction for bidder 1, [Pi.sub.1], depends on the expected value of the security in secondary market trading, [v.sub.1], less the awarded price, [b.sub.1], times the probability of winning the auction, Pr(*}. In more formal terms and using i as an index to represent the bidders in the auction,

[Pi.sub.1] = ([v.sub.1] - [b.sub.1]) *

Pr{b.sub.1 > b.sub.i, for all other i}.

The format of the auction determines how the bid price affects the probability of winning and the profit from acquiring the security, as well as what information is revealed about the security's value through the auction process.

First-Price Sealed-Bid Auction

The current practice of auctioning government securities falls into the first-price sealed-bid category, which in the financial community is termed an English auction (except by the English, who call it an American auction). Bidding takes place in private and, as diagram 1 shows, awards are made at the highest priced bids covering the total auction size. It is termed a first-price auction because in the sale of one unit of good or security the award is made at the highest bid. In the figure, the horizontal bars measure the cumulative amount of bids at the given price or higher.2 Thus, participants pay differing prices reflecting the strength of their bids.