What Is a Dutch Auction?

A Dutch auction is a market structure in which the price of something offered is determined after taking in all bids to arrive at the highest price at which the total offering can be sold. In this type of auction, investors place a bid for the amount they are willing to buy in terms of quantity and price.

A Dutch auction also refers to a type of auction in which the price of an item is lowered until it gets a bid. The first bid made is the winning bid and results in a sale, assuming that the price is above the reserve price. This is in contrast to typical auction markets, where the price starts low and then rise as bidders compete among one another to be the successful buyer.

Key Takeaways

  • In a Dutch auction, the price with the highest number of bidders is selected as the offering price so that the entire amount offered is sold at a single price.
  • This price may not necessarily be the highest or lowest price.
  • A Dutch auction may also refer to a market where prices generally start high and incrementally drop until a bidder accepts the going price.
  • This is in contrast to competitive auctions where the price starts low and is bid higher.
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What Is a Dutch Auction?

Understanding Dutch Auction for Public Offerings

If a company is using a Dutch auction initial public offering (IPO), potential investors enter their bids for the number of shares they want to purchase as well as the price they are willing to pay. For example, an investor may place a bid for 100 shares at $100 while another investor offers $95 for 500 shares.

Once all the bids are submitted, the allotted placement is assigned to the bidders from the highest bids down, until all of the allotted shares are assigned. However, the price that each bidder pays is based on the lowest price of all the allotted bidders, or essentially the last successful bid. Therefore, even if you bid $100 for your 1,000 shares, if the last successful bid is $80, you will only have to pay $80 for your 1,000 shares.

The U.S. Treasury uses a Dutch auction to sell its securities. To help finance the country's debt, the US Treasury holds regular auctions to sell Treasury bills (T-bills), notes (T-notes), and bonds (T-bonds), collectively known as Treasuries. Prospective investors submit bids electronically through TreasuryDirect or the Treasury Automated Auction Processing System (TAAPS), which accepts bids up to 30 days in advance of the auction. Suppose the Treasury seeks to raise $9 million in two-year notes with a 5% coupon. Let's assume the submitted bids are as follows:

  • $1 million at 4.79%
  • $2.5 million at 4.85%
  • $2 million at 4.96%
  • $1.5 million at 5%
  • $3 million at 5.07%
  • $1 million at 5.1%
  • $5 million at 5.5%

The bids with the lowest yield will be accepted first since the issuer will prefer to pay lower yields to its bond investors. In this case, since the Treasury is looking to raise $9 million, it will accept the bids with the lowest yield up to 5.07%. At this mark, only $2 million of the $3 million bid will be approved. All bids above the 5.07% yield will be rejected, and bids below will be accepted. In effect, this auction is cleared at 5.07%, and all successful bidders receive the 5.07% yield.

The Dutch auction also provides an alternative bidding process to IPO pricing. When Google launched its public offering, it relied on a Dutch auction to earn a fair price.

Lowest Bidding Dutch Auction

At a Dutch Auction, prices start high and are dropped successively until a bidder accepts the going price. Once a price is accepted, the auction ends. For example, the auctioneer starts at $2,000 for an object. The bidders watch the price decline until it reaches a price that one of the bidders accepts. No bidder sees the others’ bids until after his or her own bid is formulated, and the winning bidder is the one with the highest bid. So, if there are no bidders at $2,000, the price is lowered by $100 to $1,900. If a bidder accepts the item of interest at, say the $1,500 mark, the auction ends.

Benefits and Drawbacks of Dutch Auctions

The use of Dutch Auctions for initial public offerings offers benefits as well as drawbacks.

The biggest benefit of such auctions is that they are meant to democratize public offerings. As it happens currently, the process for conducting a typical IPO is mostly controlled by investment banks. They act as underwriters to the offering and shepherd it through roadshows, enabling institutional investors to purchase securities of the issuing company at a discount. They are also responsible for setting the IPO's price. A Dutch Auction allows small investors to take part in the offering.

A Dutch Auction is also supposed to minimize the difference between offering and actual listing prices. Institutional investors take advantage of this difference to rake in profits by purchasing shares at a discount and selling them immediately after the stock is listed. Dutch Auction prices are set by a fairer and more transparent method in which an array of bids from multiple types of customers are invited. This practice is meant to ensure that the market arrives at a reasonable estimate of the firm's value and that the initial "pop" that accompanies the listing of a hot company is muted.

Those benefits are accompanied by drawbacks. Because the auction is open to investors of all stripes, there is a danger that they may perform less rigorous analysis as compared to investment bankers and come with a price estimate that may not accurately reflect the company's prospects.

Another drawback of Dutch Auctions is known as the "winner's curse." In this, a stock's price may crash immediately after listing when investors, who had bid a higher price earlier, realize that they may have miscalculated or overbid. Such investors may try to sell the stock to get out of their holding, leading to a crash in the share's price.

Example of Dutch Auction

The most prominent example of a Dutch Auction in recent times was Google's IPO in August 2004. The company opted for this type of offering to prevent a "pop" in its prices on the first day of trading. While the increase in share prices is a standard phenomenon in stock markets, it had escalated to bubble territory for tech stocks during the Internet bubble of 2000. From 1980 to 2001, the pop in first-day trading was 18.8%. That figure jumped to 77% in 1999 and in the first half of 2000.

Google's initial estimate for its offering was 25.9 million between the $108 to $135 range. But the company revised its expectations about a week before the actual offering after analysts questioned the reasoning behind those figures and suggested that Google was overpricing its shares. In the revised estimate, Google offered to sell 19.6 million shares to the public at a price range between $85 to $95.

The response to the offering was considered a disappointment. Although Google was considered a hot company and offering, investors priced its shares at $85, the lower range of its estimates. By the end of the day, the shares were exchanging hands at $100.34, a pop of 17.6% during the first day of trading.

Observers blamed the poor performance on negative press reports about the company leading up to its IPO. An SEC inquiry into its executive share allocation further dampened enthusiasm for Google's offering. The company was also said to be "secretive" about its use of raised funds, making it difficult to evaluate its offering especially for small investors not aware of the emerging market for search engines and organizing information on the web.