What Is a Dutch Auction?

Anbarasan Appavu

A Dutch auction is a market structure in which the price of an item is determined by aggregating all bids to determine the maximum price at which the entire offering can be sold. In this type of auction, investors place bids for the quantity and price they are willing to purchase.

What Is a Dutch Auction?

A Dutch auction is also a type of auction in which the price of an item is gradually reduced until a bid is received. Assuming the price is above the reserve price, then the first bid placed is the winning bid as well as results in a sale. This is in contrast to traditional auction markets, in which the price begins low and then rises as bidders compete to be the winning buyer.

• In a Dutch auction, the price with the most bidders is selected as the offering price to ensure that the entire amount offered is sold for a single price.

• This price may not be the highest or lowest price.

• A Dutch auction may also refer to a market in which prices typically begin high and drop incrementally until a bidder accepts the going price.

• This is in contrast to competitive auctions, where the starting price is low and increases as bids are placed.

Understanding About Dutch Auction for Public Offerings

If a company uses a Dutch auction for its initial public offering (IPO), potential investors submit bids for the number of shares and price at which they are willing to purchase them. For instance, one investor may submit a bid for 100 shares at $100, while another investor may offer $95 for 500 shares.

Once all bids have been submitted, the allotted placement is assigned to the highest-bidding bidders in descending order until all allotted shares have been assigned. However, the price that each bidder pays is based mostly on lowest price of all allotted bidders, or, in essence, the most recent successful bid. Therefore, even if you bid $100 for 1,000 shares and the last successful bid was $80, you will only have to pay $80 for 1,000 shares if the last successful bid was $80.

The United States Treasury sells its securities through a Dutch auction. The US Treasury regularly auctions Treasury bills (T-bills), notes (T-notes), and bonds (T-bonds), known collectively as Treasuries, to help finance the country's debt. Investors submit electronic bids via TreasuryDirect or the Treasury Automated Auction Processing System (TAAPS), which accepts bids up to 30 days prior to the auction. Suppose the Treasury wishes to issue $9 million in two-year, 5% coupon bonds. Let's assume the following about the submitted bids:

• $1 million at 4.69%

• $2.5 million at 4.75%

• $2 million at 4.96%

• $1.5 million at 5.01%

• $3 million at 5.04%

• $1 million at 5.2% 

$5 million at 5.56%

The lowest yielding bids will be accepted first, since the issuer prefers to pay bond investors lower yields. In this instance, as the Treasury seeks to raise $9 million, it will accept bids with yields as low as 5.04%. Only $2 million of the $3 million bid will be accepted at this point. All bids that exceed the 5,04% yield will be rejected, while all bids that fall below will be accepted. Effectively, this auction is closed at a yield of 5.04%, and all successful bidders will receive this yield.

The Dutch auction offers an alternative bidding process to initial public offering (IPO) pricing. When Google went public, it relied on a Dutch auction to achieve a reasonable price.

Auction with the lowest bids

In a Dutch auction, prices begin high and decrease until a bidder accepts the prevailing price. When a bid is accepted, the auction concludes. For example, the starting bid for an item is $2,000. Bidders observe the price decrease until it reaches a level that one of them accepts. No bidder sees the other bidders' bids until after he or she has submitted their own, and the highest bidder wins. Therefore, if there are no bidders at $2,000, the price is reduced to $1,900, a $100 decrease. If a bidder accepts the item at, say, $1,500, the auction is concluded.

Benefits and Drawbacks of Dutch Auctions

Utilizing Dutch Auctions for initial public offerings has both advantages and disadvantages.

The greatest advantage of these auctions is that they are intended to democratize public offerings. Currently, investment banks control the majority of the process involved in conducting a typical IPO. They serve as the offering's underwriters and guide it through roadshows, allowing institutional investors to purchase securities of a issuing company at a discount. They are also responsible for determining the price of the IPO. A Dutch Auction enables smaller investors to participate in an offering.

A Dutch auction is also intended to reduce the disparity between the offer price and the actual listing price. Institutional investors profit from this disparity by purchasing shares at a discount and selling them immediately following the stock's listing. The prices at a Dutch Auction are determined by a method that is more equitable and transparent, in which bids from multiple types of customers are solicited. The purpose of this practice is to ensure that the market arrives at a reasonable estimate of the firm's value and that the initial "pop" associated with the listing of a hot company is mitigated.

These advantages are accompanied by disadvantages. Due to the fact that the auction is open to all investors, there is a risk that they will conduct less rigorous analysis than investment bankers and provide a price estimate that may sometimes not accurately reflect the company's prospects.

Apart from that another disadvantage of Dutch auctions is the "winner's curse." In this type of scenario, the price of a stock may plummet immediately after it got listed, as investors who previously bid a higher price then realize they may have miscalculated or overbid. Such investors may attempt to unload their holdings, resulting in a price decline for the stock.

Example of Dutch Auction

Google's initial public offering in August 2004 was the most notable instance of a Dutch Auction in recent history. The company chose this type of offering to prevent a price "pop" on the first trading day. While an increase in share prices is a common occurrence on stock markets, during the Internet bubble of 2000 it reached bubble proportions for tech stocks. From 1980 to 2001, first-day trading increased by 18.8%. This percentage increased to 77% in 1999 and the first half of 2000.

Initial estimates for Google's offering ranged between $108 and $135 per share. Analysts questioned the reasoning behind these figures and suggested that Google was overpricing its shares, prompting the company to revise its projections a week prior to the actual offering. Google offered to sell 19.6 million shares to the public at a price range of $85 to $95 per share, according to the revised estimate.

The response to the offering was deemed unsatisfactory. Despite the fact that Google was a hot company and offering, investors priced its shares at $85, which was the lower end of its estimates. The shares closed the day at $100.34, representing an increase of 17.6% on the first day of trading.

Observers attributed the company's poor performance to negative press coverage preceding its IPO. An SEC investigation into Google's executive share allocation further dampened interest in its offering. The company was also said to be "secretive" about its use of raised funds, making it difficult to evaluate its offering, particularly for small investors unaware of the emerging market for search engines and web-based information organization.

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