An analysis of potential Treasury auction techniques

Federal Reserve Bulletin, June, 1992 by Vincent Reinhart

Clearly, single-dealer cornering and collusive combining are similar. However, the informational requirements and incentives for these two types of strategic behavior vary across auction type, and actions taken to combat one might make the other more likely. To analyze the collusive potential in auctions, one must first understand the incentive behind cornering an auction-or the way in which one variety of squeeze can work.

How a Corner Works

The potential for profit in a comer, or squeeze, lies in the interaction of the three main trading forums for Treasury securities: the when-issued market, the Treasury auction, and the secondary market. Those markets are represented by the three panels of diagram 5, arrayed by time---before, at, and after the auction. As the right panel shows, the price of a Treasury security must satisfy the ultimate holders of securities (pension funds, insurance companies, mutual funds, and the general investing public), seen as the intersection of their downwardly sloped demand schedule with the vertical Treasury supply schedule.

Current auction procedures, however, get securities to those holders indirectly, through the intermediation of dealers. As the middle panel shows, the demand derived from current and anticipated customer orders produces a flatter and more inward schedule at the auction as a result of the shading of bids in the attempt to avoid the winner's curse.

An investor can purchase the security before the auction, as long as he or she can find someone wilting to sell it short. The when-issued market, shown in the left panel, matches those parties. Those seeking secure ownership rights trace a downwardly sloped demand schedule, while those willing to sell what they do not yet have make up the short-sale schedule. Selling a security before the auction involves a risk, as short sellers may not win awards at the auction to cover their open positions and so will have to bonow or buy the security after the auction settles to make delivery. Accordingly, the when-issued price should clear above the expected auction price.

The cornering of an auction is depicted in diagram 6. Short sales are made at a price just enough above the anticipated auction price to pay the sellers for exposing themselves to the likely risk at the auction. Those sellers, however, turn out to be wrong about the auction for, while the market consensus coalesces around bids consistent with the Demand schedule in the middle panel, one party comes in with bids that shift the actual schedule to Demand'. The cornerer exploits the sealedbid nature of the auction: By bettering the market consensus, the schemer wins the bulk of the awards (measured by the horizontal distance between the two demand schedules).

Since other parties cannot react, the Treasury receives only a modestly higher price for its auctioned securities, but the major price action awaits secondary market trading. The cornerer restricts the supply of the security in the secondary market (seen as the inward shift in the vertical supply schedule in the right panel), so that the price that clears that market is well above the auction price. From there, the cornerer slowly unwinds that position, expanding market supply to sell at prices above the ultimate level determined by the final owners of Treasuries. In effect, the cornerer acts as a discriminating monopolist, carefully regulating secondary market sales to earn all the revenue given by the area under the demand schedule. The cornerer's cost is given by the unshaded rectangle, leading to the profit given by the shaded area.