Dutch auction
Encyclopedia
A Dutch auction is a type of auction
Auction
An auction is a process of buying and selling goods or services by offering them up for bid, taking bids, and then selling the item to the highest bidder...

 where the auctioneer begins with a high asking price which is lowered until some participant is willing to accept the auctioneer's price, or a predetermined reserve price
Reservation price
In microeconomics, the reservation price is the highest price a buyer is willing to pay for goods or a service; or; the smallest price at which a seller is willing to sell a good or service...

 (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 auction.

This type of auction is convenient when it is important to auction 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
Sealed first-price auction
A first-price sealed-bid auction is a form of auction where bidders submit one bid in a concealed fashion. The submitted bids are then compared and the person with the highest bid wins the award, and pays the amount of his bid to the seller...

. The Dutch auction is named after its use in the Dutch
Netherlands
The Netherlands is a constituent country of the Kingdom of the Netherlands, located mainly in North-West Europe and with several islands in the Caribbean. Mainland Netherlands borders the North Sea to the north and west, Belgium to the south, and Germany to the east, and shares maritime borders...

 Tulip craze
Tulip mania
Tulip mania or tulipomania was a period in the Dutch Golden Age during which contract prices for bulbs of the recently introduced tulip reached extraordinarily high levels and then suddenly collapsed...

.

Auction process

In a Dutch auction, the item being sold is initially offered at a very high price, well in excess of the amount the seller expects to receive. Bids are not sealed, as they are in some types of auctions. The price is lowered in decrements until a bidder accepts the current price. That bidder wins the auction and pays that price for the item. For example, suppose a business is auctioning off a used company car: the bidding may start at $15,000. The bidders will wait as the price is successively reduced to $14,000, $13,000, $12,000, $11,000 and $10,000. When the price reaches $10,000, Bidder A decides to accept that price and, because he is the first bidder to do so, wins the auction and has to pay $10,000 for the car.

There is some confusion over terminology: some financial commentators and some third-party auction sites use the term "Dutch auction" to refer to second-price auctions, which are totally different from Dutch auctions: in a second-price auction, the winner pays the amount bid either by the lowest winning bidder or by the highest losing bidder.

Dutch auctions are a competitive alternative to a traditional auction, in which bids of increasing value are made until a final selling price is reached, because due to ever-decreasing bids buyers must act decisively to name their price or risk losing to a lower offer.

A second item auction

A second item auction can be confused with a Dutch auction or a second price auction, especially in finance. In a second item auction the seller offers more than one identical items for sale, so that there may be more than one winning bidder. Each bidder can bid for all the items or only some of them, and publicly indicates the price that he/she is willing to pay for each item. However, all winning bidders need to pay only 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 a competing bidder, one must bid a higher price per item than that competitor, regardless of the number of items that are being bid for. Here is an example of how this might work:

The seller auctions 5 identical items.
  • Bidder "A" bids for 2 items at $20 each.
  • Bidder "B" bids for 4 items at $21 each.
  • Bidder "C" bids for 3 items at $18 each.


The outcome of this auction would be:
  • Bidder "B" wins 4 items at $20 each.
  • Bidder "A" wins 1 item at $20 each.


The price is $20 because that was the lowest successful bid (hence the "second price"). Since Bidder "A" was only awarded 1 item, and his original bid was for 2 items, he has the right to refuse the purchase of that partial amount. As a winning bidder, you have the right to refuse paying if you are only awarded less than the number of the items you were bidding on.

Public offerings

The United States Department of the Treasury
United States Department of the Treasury
The Department of the Treasury is an executive department and the treasury of the United States federal government. It was established by an Act of Congress in 1789 to manage government revenue...

, through the Federal Reserve Bank of New York
Federal Reserve Bank of New York
The Federal Reserve Bank of New York is one of the 12 Federal Reserve Banks of the United States. It is located at 33 Liberty Street, New York, NY. It is responsible for the Second District of the Federal Reserve System, which encompasses New York state, the 12 northern counties of New Jersey,...

 (FRBNY), raises funds for the U.S. Government using a Dutch auction. The FRBNY interacts with primary dealers
Primary dealers
Primary dealer is a formal designation of a firm as a market maker of government securities. Primary dealer systems are present in many countries including Canada, France, Italy, Spain, the United Kingdom, and the United States...

, 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 issurance is seeking to raise $10 billion in ten-year notes with a 5.125% coupon and in aggregate the bids are as follows:
  • $1.00 billion at 5.115% (highest bid)
  • $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% (lowest bid)


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, OpenIPO
OpenIPO
OpenIPO is an innovative auction process pioneered by the investment bank WR Hambrecht + Co for distributing stock in an initial public offering to individuals and institutions through an efficient and equitable process. It is a modified Dutch auction process which allows shares of an initial...

, was used on the IPO for Google
Google
Google Inc. is an American multinational public corporation invested in Internet search, cloud computing, and advertising technologies. Google hosts and develops a number of Internet-based services and products, and generates profit primarily from advertising through its AdWords program...

 stock. SRECTrade.com uses a two-sided Dutch auction to trade Solar Renewable Energy Credits (SRECs).

Dutch auction share repurchases

The introduction of the Dutch auction share repurchase in 1981 allows firms an alternative to the fixed price tender offer
Tender offer
Tender offer is a corporate finance term denoting a type of takeover bid. The tender offer is a public, open offer or invitation by a prospective acquirer to all stockholders of a publicly traded corporation to tender their stock for sale at a specified price during a specified time, subject to...

 when executing a tender offer share repurchase
Share repurchase
Stock repurchase is the reacquisition by a company of its own stock. In some countries, including the U.S. and the UK, a corporation can repurchase its own stock by distributing cash to existing shareholders in exchange for a fraction of the company's outstanding equity; that is, cash is exchanged...

. The first firm to utilize the Dutch auction was Todd Shipyards. A Dutch auction offer specifies a price range within which the shares will ultimately be purchased. Shareholders are invited to tender their stock, if they desire, at any price within the stated range. The firm then compiles these responses, creating a supply curve for the stock. The purchase price is the lowest price that allows the firm to buy the number of shares sought in the offer, and the firm pays that price to all investors who tendered at or below that price. If the number of shares tendered exceeds the number sought, then the company purchases less than all shares tendered at or below the purchase price on a pro rata basis to all who tendered at or below the purchase price. If too few shares are tendered, then the firm either cancels the offer (provided it had been made conditional on a minimum acceptance), or it buys back all tendered shares at the maximum price.
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