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The Upside-Down World of Dutch Auctions

If you think Dutch auctions work in the same way as your average, simple auction, you are grossly mistaken! These interesting bidding transactions work in a way that is opposite to our general view of how bidding works.

A Dutch auction is where the auctioneer begins with a high asking price, which is systematically lowered until some participant is willing to accept the auctioneer’s price, or a predetermined reserve price (the seller’s minimum acceptable price) is reached. The winning participant pays the last announced price.

This is also known as a “clock auction,” or an open-outcry descending-price. This type of transaction is convenient when it is important to get rid of goods quickly, since a sale never requires more than one bid.

Theoretically, the bidding strategy and results of this auction are equivalent to those in a sealed first-price auction. The Dutch auction is named for its use in the Dutch Tulip Craze.

There is also another kind of bid, called the second price auctions, which is often referred to as a Dutch auction, as well. In a “second price,” the seller is offering two or more of an identical item.

Unlike a standard auction, a second price may have more than one winning bidder. Each bidder bids on either all, or a desired number of the items, and indicates the price that he/she is willing to pay for each of item.

At the end, all winning bidders will pay the same price for each of their items, which is the lowest qualifying (successful) bid. If there are more successful bids than items available, priority goes to the bidders who submitted their bids first.

In order to beat another bidder, a bid must simply have a higher total bid price per item than the other bids, regardless on the number of items that are being bid on. Here is a way in which these auctions may work.

The seller lists a second price auction with five identical items. The first bidder places a bid for two items at twenty dollars each.

The second bidder will then place a bid for four items at twenty one dollars each. In this particular auction, the second bidder wins four items at twenty dollars each, and the first bidder wins only one item for twenty dollars.

The twenty dollar price is because the lowest successful bid was twenty dollars, hence the “second price.” The total items were awarded based upon the second bidder’s willingness to bid a higher dollar amount than the first bidder.

Since the first was only awarded one item, and his original bid was for two items, he has the right to refuse the purchase of that partial order. So, as a winning bidder, you have the right to refuse paying if you are only awarded a partial number of the items you were bidding on.

The United States Department of the Treasury, through the Federal Reserve Bank of New York (FRBNY), raises funds for the U.S. Government using a Dutch auction. The FRBNY interacts with primary dealers, including large banks and broker-dealers who submit bids on behalf of themselves and their clients using the Trading Room Automated Processing System (“TRAPS”), and are generally told of winning bids within fifteen minutes.

For example, suppose the sponsor of the issuance is seeking to raise ten billion dollar in ten-year notes with a 5.125% coupon and in aggregate the bids are as follows: $1.00 billion at 5.115%, $2.50 billion at 5.120%, $3.50 billion at 5.125%, $4.50 billion at 5.130%, $3.75 billion at 5.135%, $2.75 billion at 5.140%, $1.50 billion at 5.145%. In this example the % at high is 66.66%, meaning only $3 billion of the $4.5 billion at 5.130% will get bonds.

Bids will be filled from the lowest yield (highest price) until the entire $10 billion has been raised. This auction will clear at a yield of 5.130%, and all bidders will pay the same amount.

In theory, this feature of the Dutch auction format leads to more aggressive bidding as those who in this case bid 5.115% will receive the bonds at the higher yield (lower price) of 5.130%. A variation on the Dutch auction, Open IPO, was used on the IPO for Google stock. SRECTrade uses a two-sided Dutch auction to trade Solar Renewable Energy Credits (SRECs).

As you can see, these interesting contradictions to traditional bidding are very interesting. To try a change of pace, check out a Dutch auction today!

Tommy Greene has worked as an auctioneer for the past 18 years and written hundreds of articles about penny auctions and Bidsauce.

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Tom Selwick