Treasury Management for Governments

Q 7-05.08.   How are bonds sold by auction?
In most developed countries, government bonds are distributed through public sale auctions.  The auctions are generally open so that both members of the public and banks may bid for the bonds.  Bidding may be on the coupon rate for a par price or on the price for a stated coupon rate[1].  Both cannot be set simultaneously by the auction mechanism. 

The choice of bidding on rate or price has some impact on the treasury and future budgets.  If bidding is on the coupon rate, the total amount of funds that the treasury will take in from the sale, assuming the entire lot is sold, will be known in advance.  The cost of financing the borrowing, however, is unknown until the conclusion of the auction.  If bidding is on the price, the amount of the future stream of coupon payments is known, but how much money will be borrowed is not.     

Q 7-05.09.   What are the choices if the sale is by auction?
Auction mechanisms require care in developing to maintain a level playing field, to protect against collusive practices, and to obtain the best possible terms for borrowing.  The principal decisions are whether the auction will be conducted secret bidding or open cry and whether the auction will yield a multiple price or single price determination.  In both situations, strategic or game theoretic considerations on the part of the participants will be drive their behavior under these choices.

Q 7-05.10.   What are the implications of using secret bid or open cry auctions?
Open cry auctions are the very model of a perfectly competitive market in the view of a micro-economist.  What this assumes, however, is that no one bidder has significant market strength to affect market prices or dynamics that drive other bidders’ decisions.  For states with a nascent sovereign debt market, this is rarely true.  When there are only a few bidders, there is a significant risk of collusion in setting bids.  An open cry market makes it easier for such a scheme to be successful because it is easy to determine who has broken faith with the bloc and this allows group discipline to be enforced.  A secret bid in this case weakens the power of collusive arrangements because it is not immediately clear who has broken ranks.

Once the number of bidders becomes sufficiently large, even if some brokers are serving as order-takers for other bidders, the risk of collusive behavior abates.  At that point, however, an open cry model may also be infeasible for sheer physical considerations.
 
Q 7-05.11.   What are the implications of using single or multi-price auctions?
The advantage for the seller in using multi-price auctions lies in capturing additional revenue forgone by the seller in single price markets.[2]  By selling to each buyer at an individual price, the seller maximizes his revenue.  The ability to extract the additional revenue is a measure of the seller’s monopoly power for some market good.  The risk of exercising such power too strongly is to encourage the use of substitute goods.  

In multi-price auctions, an unintended second consideration comes into play.  Bidders’ success is based not just whether or not they obtain the security on which they have bid, but on the price they paid for the instrument relative to the prices paid by all other successful bidders.  Every bid above the auction cutoff might be seen as paying an unnecessarily high price for the debt security.  After all, the next lowest successful bid got the same security for a slightly more favorable price. 

This situation leads to the “winner’s curse” paradox in which a successful bid itself is evidence of having paid too much for an asset.  The rational response by all bidders in auctions in this case is to bid less aggressively by including a risk premium in the bid to prevent the bidder from winning by bidding a price higher than necessary to win.  The net effect across all bidders is to lower the full set of bids with an increase in financing costs for the state. 

A single-price (“Dutch”) auction reduces the risk of the “winner’s curse” and encourages more aggressive bidding.  In a single-price auction, all successful bids are won at the same price.  This frees the bidders to pursue the security in the auction without secondary considerations about relative bids.  The result is a likely lower financing cost for the borrower.

Q 7-05.12.   What are primary dealers? 
Primary dealers are financial entities designated by the ministry of finance or by the central bank to serve as market makers in government securities.  As such, they are expected to participate actively and regularly in the sale or auction of all government debt.    

Primary dealer systems are present in many countries including Canada, France, Italy, Spain, the United Kingdom, and the United States.  In the United States, primary dealers purchase a large share of the U.S. Treasury securities (bills, notes, bonds, and TIPS) sold at auction, and resell them to the public.  The primary dealers form a worldwide network that distributes new U.S. government debt.

Q 7-05.13.   On what basis are primary dealers selected?
A primary dealer should be expected to maintain a prolonged relationship with the ministry or the central bank and with the debt market.  The selection of primary dealers should be based upon their commitment to maintaining a market for sovereign debt, the strength of their capital structure, and their reputation in the market.    

[1] For a zero coupon bond (or a treasury bill), bidding on price is equivalent to bidding on yield.
[2] This additional revenue is referred to in economics as “consumer surplus” and is equal to the area under the demand curve that is above the market-clearing price.

Praxis: Debt -  Auctions and auction rules