An analysis of potential Treasury auction techniques

Federal Reserve Bulletin, June, 1992 by Vincent Reinhart

In terms of the expected return from winning the auction, a high bid lowers the profit from victory and raises the probability of winning. The strategic bidder trades between the two: He or she lowers the bid relative to valuation in order to profit more from winning and accepts the risk of lowering the probability of winning. The optimal strategy is to shade a bid toward the perceived market consensus; the more certain that consensus is (in terms of lower variability), the more the strategic investor will shade his or her bid.3

Another factor comes into play in the commonvalues case: Since all participants guess about the price--where the security will trade after the auction--a high bid signals a heightened probability of subsequent loss of profit for that bidder. In that sense, winning is losing, as entering the highest bid signals that one's valuation exceeds that of all other interested parties. This is the "winner's curse" and gives aggressive bidders an additional reason to rein in their enthusiasm. Avoiding the winner's curse may lead to the pooling of bids, as a group of investors is more likely to have a clearer view of the market consensus and is less likely to be in the far end of the bid-price distribution. The pooling of bids is a service provided by dealers, who collect customer business and place largescale orders.

Second-Price Sealed-Bid Auction

The Treasury could collect sealed bids, arrange them by price, and award all the securities at a single price that just places the entire issue (diagram 2). This auction is termed second-price because, when a single unit is on the block, the price charged would be that of the highest bid below the price that places the issue, or the second-best price. The second-price auction, called a Dutch auction in the financial press, has been proposed as a simple alternative to current Treasury practice that would prevent the type of abuses witnessed last year while lowering average borrowing costs.4

A second-price auction, in which the winner pays, not his or her bid, but only the second-best bid, severs the gain in winning from the probability of winning. An aggressive bidder can receive a sure award but pay a price closer to the market consensus. As a result, less of the shading that marks the response to the winner's curse should occur. Accordingly, customers may be more willing to place their business directly by bidding at the auction than to go through a dealer.

Descending-Price Open-Outcry Auction

This procedure is used to auction flowers in the Netherlands, hence it is referred to by academics as a Dutch auction. Bidders congregate in one room, or plug into its electronic equivalent, and wait as the auctioneer calls out a sequence of decreasing prices. In an auction of one unit of a good or security (diagram 3), the auction stops when one bidder is willing to pay the price called out. For multiple units, the eager bidder is awarded the security, and the auction continues, with the auctioneer selling the remaining securities at progressively lower prices. The strategic decision is identical to that of the first-price sealed-bid auction: The optimal bidder does not want to be too aggressive and stop the auction well above the likely market consensus, but will shade his or her bid to avoid the winner's curse. In other words, what market participants refer to as an English auction is strategically identical to what academics refer to as a Dutch auction. As a result, investors have the same incentive to pool bids and place customer orders at dealers.