A Dutch auction is a type of auction in which 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 (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.
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.
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 higher offer.
A second price auction
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 different from Dutch auctions.
In a second price auction, the seller offers more than one identical item 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 "High" bids for 4 items at $21 each.
- Bidder "Mid" bids for 2 items at $20 each.
- Bidder "Low" bids for 3 items at $18 each.
The outcome of this auction would be:
- Bidder "High" wins all the items they sought (qty 4), at $20 each.
- Bidder "Mid" wins 1 of the 2 items they sought (because no more remain), also at $20 each.
The price is $20 because that was the lowest successful bid (hence the second price). Since Bidder "Mid" 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 only if you are awarded less than the number of the items you were bidding on. If this were a Dutch Auction, the first bid made wins the item, regardless of value.
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 $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, was developed by WR Hambrecht and has been used for 19 IPOs in the US. Auctions have been used for hundreds of IPOs in more than two dozen countries, but have not been popular with issuers and thus were replaced by other methods. One of the largest uniform price or "Dutch" auction IPOs was for Singapore Telecom in 1994. The 1994 auction IPO of Japan Tobacco was substantially larger (with proceeds more than double those of Singapore Telecom and triple those of Google), but this auction was discriminatory or pay-what-you-bid, not uniform price or "Dutch". SRECTrade.com uses a two-sided Dutch auction to trade Solar Renewable Energy Credits (SRECs).
The introduction of the Dutch auction share repurchase in 1981 allows firms an alternative to the fixed price tender offer when executing a tender offer share repurchase. 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.
- To understand the Dutch auction bidding and outcome from actual shareholder tendering responses, see Bagwell, Laurie Simon, "Dutch Auction Repurchases: An Analysis of Shareholder Heterogeneity,". 1992. Journal of Finance, Vol. 47, No. 1, 71–105.