An analysis of potential Treasury auction techniques

Federal Reserve Bulletin, June, 1992 by Vincent Reinhart

Opening the auction might create new opportunities for large traders to move prices. For example, the surprising presence of a large trader elevating demand during the early stages of an auction might lead to a groundswell of enthusiasm that would push up the market-clearing price.|3 Similarly, the sudden dropping out by a large trader at a low price might dampen spirits enough to lower the marketclearing price. Either action might present the potential for profit. Also, as long as the three trading forums in Treasury securities are imperfectly integrated, the possibility of a market squeeze remains. At the least, an open-outcry auction does not abet a squeeze attempt by facilitating the bidding away of securities by surprise, as both types of sealed-bid auctions do. Thus, the Treasury would be less likely to be the counterparty from which a manipulator amassed a controlling position. Further, with easy entry, large traders would be pitted against each other in their pursuit of trading profits, as an open-outcry system turns market forces against market manipulation. As an added benefit, the technical sophistication required to conduct an automated open-outcry system could also be made available for surveillance regarding compliance with the auction rules.

CONCLUSION

While the academic literature suggests that the current Treasury procedure has drawbacks, it does not readily identify the best way to auction government securities. Individual elements of the problem are addressed, but other considerations do not fit nicely into the theoretical models. The Treasury is obliged to provide easy entry into the auctions, broadening, where possible, the ownership of the public debt; and it must adhere closely to a crowded schedule of borrowing. Also, while the Treasury may not always get top dollar for its issues, the present auction system may ease the conduct of monetary policy and ensure a deep and active secondary market in government obligations.

The shift to single-price awards may mark an improvement over the current technique, but it may not avoid the repetition of recent experience. No matter how rigidly rules are enforced, the incentive to manipulate the market remains.

This reading of the literature suggests that the optimal Treasury auction would have the following attributes (in order of decreasing importance):

* Second price. If all securities are awarded at the lowest price of an accepted bid, investors wary of the winner's curse may enter the auction directly. Such entrance raises total demand because bidders no longer feel the need to shade their bids. Also, by making direct bidding more attractive, individual dealers will no longer have as much access to customer business in attempts to swing the market.

* Real time. Auctions involving many participants that are conducted on an open-outcry basis are less susceptible to corners, which rely on surprise. In a sealed-bid auction, such surprise requires only stepping above the market consensus. That surprise is lost if market participants can react during the bidding.