An analysis of potential Treasury auction techniques

Federal Reserve Bulletin, June, 1992 by Vincent Reinhart

Ascending-Price Open-Outcry Auction

The auctioneer can just as well cry out an ascending sequence of prices to the gathered bidders, stopping the auction when enough are willing to take down the total issue. Such a price sequence is plotted in diagram 4 for the auction of a single good or security. In keeping with the mirror imaging, academics term this an English auction.5

The auction of multiple units of a security begins as a price is called out and all interested parties submit their quantities demanded. The volume of bids at that price is announced and, in successive rounds, the price is raised until the volume demanded is smaller than the issue. When that point is reached, the seller knows that the price just previously called out is the highest price consistent with placing the entire issue--that is, it clears the primary market. Everyone who bids at the top price and some fraction of the bidders at the previous price not in the top group receive awards at that lower price.6 As the auctioneer calls out an increasing price list, bidders receive news that participants prize the security more highly than those low quotes. In effect, the auctioneer's initial announcements role out low-price outcomes, revealing that the true market value is probably higher. This increasing sequence of prices lessens the winner's curse. Besides, if an investor is truly alone in valuing the security highly, the auction stops before the price is pushed too far up when the other bidders drop out.

In 1961, Vickrey established that the four major auction formats provide equal proceeds to the seller when individual valuations are independent. Obviously, the Treasury market violates this assumption, as the value that bidders place on the security reflects an imperfect estimate of the price in subsequent market trading--that is, bidders in a Treasury auction care about the common value of the security. In the common-values case, as later researchers showed, an ascending-price open-outcry delivers the greatest proceeds to the seller under many clrcumstances.7 Essentially, in such an auction, bidders condition their behavior on the highest expected value of the security and shade their bids the least relative to the other formats.

THE POTENTIAL FOR PROFIT IN AUCTIONS

The current auction format elicits one form of strategic behavior: Because awards are priced at the bid, the participants have incentives to shade their bids to avoid the winner's curse. As a result, customers have an incentive to pool their bids with dealers so that a combination of bids can, by a law of large numbers, be appropriately cast. The auction format may encourage two other types of strategic behavior as well. First, a dealer may combine with a customer to comer a significant portion of one auction--70 percent under the current rules. This strategy is called single-dealer cornering. Second, a group of dealers can conspire to accomplish the same end; this strategy is called collusive combining. In a sealed-bid auction, to garner the lion's share of awards, the single strategist or the group need make only a slightly more aggressive bid than the other participants expect. Indeed, the second-price auction, a popular candidate to replace the current format, may make these strategies less expensive for the purchasers than they would be under current practice. The strategic purchaser could corner the issue by bidding substantially more than the market consensus but pay a price closer to the mass of the distribution that marks the other bids.