Discriminatory auction

What Is Discriminatory Auction?

A discriminatory auction, also known as a multiple-price auction or pay-as-bid auction, is an auction format within auction mechanisms where successful bidders pay the exact price they bid for the asset. In contrast to a uniform-price auction, where all winning bidders pay the same clearing price, a discriminatory auction awards different prices to different bidders based on their individual bidding levels. This format is commonly used in various financial markets for the issuance of financial instruments.

History and Origin

The concept of auctions in finance has a long history, with the U.S. Treasury utilizing auctions for Treasury bills since their introduction in 1929³⁴. Initially, these auctions, including those for coupon-bearing securities introduced in the early 1970s, often followed a multiple-price format, essentially a discriminatory auction³³. This meant that successful bidders for government debt paid the specific yield they had offered³¹, ³². The U.S. Treasury, for instance, implemented a "multiple-price" auction format in 1947, where winning bidders paid their individual bid price. This approach was intended to foster more aggressive bidding and potentially reduce the government's interest rates on borrowing.

Key Takeaways

• In a discriminatory auction, winning bidders pay the exact price they submitted, leading to potentially different prices for different winners.
• This auction format is also known as a multiple-price or pay-as-bid auction.
• Discriminatory auctions can incentivize bidders to submit bids closer to their true valuations but may also amplify the "winner's curse."
• They have been historically used for issuing government debt, although many markets have transitioned to uniform-price formats.
• The effectiveness of discriminatory auctions compared to uniform-price auctions in terms of revenue and market efficiency remains a subject of ongoing study in auction theory.

Interpreting the Discriminatory Auction

In a discriminatory auction, participants submit bids specifying both the quantity of the asset they wish to acquire and the price (or yield, in the case of debt securities) they are willing to pay for that quantity. The auctioneer then ranks these bids from highest to lowest price (or lowest to highest yield for debt) and accepts them until the desired quantity of the asset is sold. Each successful bidder then pays the exact price they stated in their bid.

This means that if Bidder A bids $100 for 100 units and Bidder B bids $99 for 100 units, and both bids are accepted, Bidder A pays $100 per unit, and Bidder B pays $99 per unit. This contrasts with a uniform-price auction, where both would pay the same clearing price. The direct consequence is that bidders in a discriminatory auction face the risk of overpaying relative to other successful bidders if their assessment of the asset's true market price is too optimistic. This can lead to what is known as the "winner's curse," where the winning bidder may have overvalued the item²⁸, ²⁹, ³⁰.

Hypothetical Example

Imagine a government agency is conducting a discriminatory auction to sell 1,000 units of a newly issued government bond. Bidders submit competitive bids with the yield they are willing to accept (lower yield means higher price).

Here are the submitted competitive bids:

• Bidder X: 300 units at a yield of 3.00%
• Bidder Y: 400 units at a yield of 3.05%
• Bidder Z: 500 units at a yield of 3.10%
• Bidder A: 200 units at a yield of 3.15%

The agency starts by accepting the lowest yield bids:

1. Bidder X's 300 units at 3.00% are accepted. (Remaining: 700 units)
2. Bidder Y's 400 units at 3.05% are accepted. (Remaining: 300 units)
3. Bidder Z's 500 units at 3.10% are submitted, but only 300 units are needed to reach the 1,000-unit target. Bidder Z is partially awarded 300 units at 3.10%.

In this discriminatory auction:

• Bidder X pays a price corresponding to a 3.00% yield for their 300 units.
• Bidder Y pays a price corresponding to a 3.05% yield for their 400 units.
• Bidder Z pays a price corresponding to a 3.10% yield for their 300 awarded units.

Each winning bidder pays their own bid, demonstrating the discriminatory nature of the auction.

Practical Applications

Discriminatory auctions are primarily found in financial primary market settings, particularly in the issuance of debt securities. Historically, the U.S. Treasury used a multiple-price format for its Treasury bills and notes for many decades²⁷. While the U.S. Treasury transitioned to a uniform-price auction format for most marketable securities in the 1990s to promote competitive bidding and liquid secondary market trading, some countries continue to use discriminatory auctions for their government debt²⁵, ²⁶.

Central banks and other public entities might employ discriminatory auctions when aiming to maximize immediate revenue from asset sales, as bidders might be encouraged to bid higher, fearing that a lower bid won't secure them the desired quantity²⁴. For instance, certain electricity markets have also explored and, in some cases, adopted discriminatory-price auctions for allocating energy capacity, with studies examining their efficiency compared to uniform-price mechanisms²³. The Federal Reserve, in its implementation of monetary policies, has also used discriminatory-price auctions for the purchase of agency mortgage-backed securities (MBS)²².

Limitations and Criticisms

One of the primary criticisms of discriminatory auctions is their potential to exacerbate the "winner's curse" phenomenon²⁰, ²¹. In such auctions, the winner is often the bidder with the most optimistic (and potentially overestimated) valuation of the asset, leading them to overpay¹⁹. This risk of overpayment can cause bidders to shade their bids, meaning they bid less aggressively than their true valuation to protect against the winner's curse, which may reduce overall demand and potentially lower the auctioneer's revenue¹⁷, ¹⁸.

Another concern is the potential for reduced participation or less competitive bidding, particularly from smaller or less experienced market participants, who might be more susceptible to the winner's curse or find the strategic complexity of bid shading challenging¹⁶. This can lead to a less diverse pool of bidders and potentially impact market efficiency. Furthermore, while discriminatory auctions may offer less room for powerful market players to exercise market power compared to uniform-price auctions, the overall effect on revenue and efficiency is not definitively clear and can vary depending on specific market conditions and bidder characteristics¹³, ¹⁴, ¹⁵. The possibility of collusion among bidders also remains a challenge in various auction formats, though some studies suggest that discriminatory auctions might be more resistant to price-reducing cartels under certain conditions¹².

Discriminatory Auction vs. Uniform-Price Auction

The key distinction between a discriminatory auction and a uniform-price auction lies in how the winning bidders pay for the assets.

Historically, the U.S. Treasury shifted from discriminatory to uniform-price auctions for most of its marketable securities, with the change primarily occurring in the 1990s for notes and bonds¹⁰, ¹¹. This change was prompted, in part, by the aim to reduce underpricing (when the average price received by the Treasury is less than the secondary market price) and encourage broader participation⁸, ⁹. While underpricing persisted, it was significantly reduced under the uniform-price mechanism⁷.

FAQs

What is the main difference between a discriminatory auction and a uniform-price auction?

In a discriminatory auction, each successful bidder pays the price they individually offered. In contrast, in a uniform-price auction, all winning bidders pay the single lowest price that clears the market, regardless of their specific bid⁵, ⁶.

Why is it also called a "pay-as-bid" auction?

The term "pay-as-bid" directly describes the mechanism: winning bidders literally "pay as they bid." Their submitted bidding price is the price they are obligated to pay if their bid is accepted.

What is the "winner's curse" in the context of a discriminatory auction?

The "winner's curse" is a phenomenon where the winning bidder in an auction tends to overpay for the item, particularly in common value auctions where the true value is uncertain. In a discriminatory auction, a bidder who submits a very high bid to ensure winning might end up paying more than the asset's actual worth, especially if their valuation was more optimistic than others³, ⁴.

Are discriminatory auctions still used today?

While many major financial markets, like the U.S. Treasury market, have moved to uniform-price auctions, discriminatory auctions are still employed in some contexts globally for issuing government bonds and other financial instruments¹, ². Their usage can depend on the specific goals of the issuer and the characteristics of the market.