Dutch auction: what it is and how it works

What a Dutch auction is

A Dutch auction is one kind of auction among several for buying and selling goods. In the form most commonly meant, the auctioneer opens with a high amount and lowers it in turn until a participant accepts that figure, or until it reaches a set reserve. It is used most often for goods that sell quickly, among them flowers, fresh produce and tobacco. People also call it a clock auction, or an open-outcry descending auction.

In this format a sale never calls for more than one bid, which gives it speed. Strategically, it is similar to a sealed-bid auction where the highest bid wins. Before the auction begins, the auctioneer presents bidders with information about the objects being sold, shown on a clock or electronic device facing the room. The auctioneer then offers an item above the amount the seller expects to receive. The amount comes down in steps until a bidder accepts the current figure. That bidder wins and pays that sum.

For example, a business could offer a used company car with an opening figure above what the seller hopes to receive. If nobody accepts, the seller cuts the amount in steps. When it reaches a level one bidder finds acceptable, and who thinks another buyer might act soon, that bidder accepts and pays that sum.

Early history and the name

Herodotus relates an account of an auction with a falling figure in Babylon, which suggests that markets used a comparable method in ancient times. In 17th-century Holland, sales of estates and paintings were held in this manner. By the 17th century the Dutch way of auctioning had reached England, where it was known as "mineing". In that auction, described as a "Method of Sale" not previously used in England, the auctioneer opened at a high amount, then reduced it step by step until one bidder cried out "Mine".

A Dutch auction appeared in The Times in 1788.

How the bidding works

In a Dutch auction, bidders cannot see the bids of other participants. They can only see the winning bid. That creates greater uncertainty about how competitive the auction is. Losing brings a stronger emotional response than winning, because the win is instant and sure, while losing comes abruptly and as a surprise. Bidders are more likely to feel winner regret, the belief that they paid too much, and loser regret, the belief that they bid too low, because the format gives them no other bids to read as signals.

The speed of the clock affects the amounts finally paid and the auctioneer's revenue. Research has found that a fast Dutch clock yields significantly lower bids and lower seller revenue than a sealed-bid auction in which the highest bid wins. A clock that runs slowly enough has been found to earn the seller more than such an auction does. Individual differences among bidders may also influence how profitable the auction is to the auctioneer.

Older bidders have been found to perform worse in Dutch auctions, a difference the research calls statistically significant. Older bidders often end up paying too much because of cognitive limitations and a high need for closure. When two or more bidders take part, bid reductions are expected to increase. The auctioneer's expected revenue increases when the number of participants rises and the number of bid levels increases. The auctioneer is also expected to increase revenue when bidders show the Allais paradox, because bidders already have bidding preferences but not enough time to change them and typically act on their first plan.

Public offerings and share repurchases

Compared with the standard book building method, the Dutch format has been considered for public offerings and for working out what an issue is worth. It has been praised as more efficient and fairer, because it can stop underwriters from handing stock to clients they know or favour. One suggestion is that any gain in efficiency in the IPO market would more likely show in larger companies that are already publicly listed, because the buyers tend to be hedge funds or mutual funds. The market has already settled the value of their shares, and an idea of the issue size is already there.

In the United States, the Treasury raises funds for the government through a Dutch auction. The Federal Reserve Bank of New York handles the process, dealing with primary dealers, among them large banks and broker-dealers, who bid for themselves and their clients. In a Dutch auction share repurchase, a firm sets a range within which shares can be bought. Shareholders may tender stock at any figure in that range. The firm builds a supply curve from the responses and pays the lowest amount that lets it buy the number of shares it seeks. If too many shares are tendered, it buys less than all tendered at or below that level, pro rata. If too few come in, the company either cancels the offer, when it was conditional on a minimum acceptance, or it takes all the shares tendered at the highest figure in the range.

Hundreds of IPOs have been run as auctions in more than two dozen countries, but issuers did not favour them, and other methods took their place. Singapore Telecom held one of the largest IPOs of this uniform or "Dutch" auction kind, in 1994. The IPO form has drawn criticism over possible tacit collusion and cartel-like behaviour, because the issuer has discretion over the amount and the allocation. That concern is said to be more common in primary market transactions. eBay formerly offered, until 2009, a listing style for multiple quantities rather than a traditional Dutch auction. It let a person bid by naming an amount and a quantity together. This mechanism has been called an ascending "Dutch" auction with one uniform figure. Units went to the bids whose combination of figure and quantity came to the largest total. Each winner paid the lowest winning figure, and each still got the quantity asked for in their original bid. Critics have said the eBay arrangement was not a Dutch auction at all, because in a Dutch auction the quantity a bidder asks for is what is guaranteed, not the figure.