Chapter 3

1. Chapter 3 Treasury Auctions and Selling Mechanisms

2. Overview • This purpose of this chapter is to provide you with an understanding of the mechanics of the primary Treasury market – that is, how the Treasury issues debt to the public. • Key issues include: • Auction mechanisms • The role of private information in market mechanisms • The importance of a pre-issue market. • Mechanics of the “When Issued” market. • Short squeezes • Market failures versus the failure of market mechanics

3. Overview • This chapter gets into extreme detail about Treasury auctions – probably more detail than most people that are not trading in that market care to know about. • It is an extremely good chapter, however, for those of you coming from a mathematics background, because it demonstrates many of the practical, day-to-day difficulties that markets participants really face. • It also demonstrates how difficult building quantitative models in finance is without a thorough understanding of how market mechanics affects prices, which ultimately affects the data used to create financial models.

4. Basic Market Functions • The goal of any market is allocate scarce resources in the most efficient manner possible. • By most efficient we normally mean with the least waste in the system. • For example, if we are trying to figure out how to allocate food, we want to insure that whatever scheme we use to allocate food, all food is allocated to somebody – we don’t want any food spoiling. • Consider for a moment an example where we are trying to distribute a single asset (W) between two people (A and B). If we assume that there is a total amount (WQ) available to be split, we can allocate to each person an amount (WA, WB) such that: WQ ≥ WA + WB.

5. Basic Market Functions Quantity Allocated to A WQ InfeasibleRegion FeasibleRegion Quantity Allocated to B WQ

6. Basic Market Functions Quantity Allocated to A Feasible, but inefficient allocations: WQ > WA + WB WQ Quantity Allocated to B WQ

7. WA1 WA2 WB1 WB2 Basic Market Functions Quantity Allocated to A • Efficient Frontier • all allocations along this line are efficient. • These allocations are sometimes said to be “pareto efficient”. WQ Quantity Allocated to B WQ

8. Basic Market Functions • There are any number of ways that society can organize itself to organize scarce resources. • Markets, central planning, bribery/corruption etc. • Economists have proven that, under certain very broad and general conditions, competitive markets tend to result in an efficient allocation of scarce resources. • Actually, they tend to create the most efficient allocations – there is, unfortunately, almost always some form of inefficiency. • Sources of inefficiency include: • Information Asymmetries • Economic externalities • Government regulation

9. Basic Market Functions • When financial economists talk about markets, we tend to use some basic ideas drawn from microeconomic theory. • Although there are some exceptions, we assume that if the price of a good rises, the quantity of it that is demanded will drop. • This leads to demand-curves that are downward sloping with respect to price. • As the price of a good rises, we assume that the supply of that good will increase. • Hence, supply curves are upward sloping with respect to price. • In an efficient market, there will be an intersection of the demand and supply curves, the price at that intersection will be the “market clearing” price.

10. Basic Market Functions • At the market clearing price the total quantity demanded by the public will exactly equal the total quantity supplied by the market, there will be no wasted resources.

11. Basic Market Functions Quantity of a good Increasing Quantity in Market • Demand Curve • As price increases, demand decreases Price of a good 0 Increasing Price

12. Basic Market Functions Quantity of a good • Supply Curve • As price increases • supply increases Increasing Quantity in Market Demand Curve Price of a good 0 Increasing Price

13. Basic Market Functions Quantity of a good Increasing Quantity in Market Market-clearing price and quantity. QMarket Price of a good PMarket 0 Increasing Price

14. Basic Market Functions Quantity of a good Wealth gain from trading activities Increasing Quantity in Market Price of a good 0 Increasing Price

15. Treasury Auctions • There are actually a number of different ways to implementing competitive markets, and auctions are one of them. • Even once one has decided upon an auction as the mechanism for implementing a competitive market, one has to decide upon the specific type. • Open-outcry methods – Like in commodity futures. • Dutch-auctions – sometimes called “second-best” auctions. • Discriminatory auctions (sealed bid, “first price” auctions). • Reverse auctions

16. Treasury Auctions • The US Treasury has used both sealed bid, first price auctions and Dutch Auctions in the past. All US Treasury Auctions Today are Dutch Auctions. • One important issue to keep in mind is that the Treasury, unlike most e-bay sellers, wishes to sell much more product than any one buyer would want to buy. • In fact it is illegal for any one party to buy more than 35% of one issue – the case study of Salomon Brothers shows what happens if you exceed that number. • Since the Treasury does not know the exact price/yield they will receive, they can’t fully specify the contractual details of the bond. As a result, the dealers bid in terms of yield, not in terms of price. • Also, there is a “non-competitive” part of the auction, which is designed for individuals and smaller competitors.

17. Treasury Auctions • Sealed-Bid, discriminatory auctions • Treasury accepts bids from dealers stating both a price and a quantity. • Dealers are free to submit multiple bids with different price/quantity amounts, although all bids are “live” in the sense that all of them could be hit. • Treasury starts by selling to the highest price bidder first until their quantity has been filled, then going to the second highest bidder, etc. until there is no more of the bond to distribute. • This leads to the “winners curse”, i.e. the notion that the person who wins the auction has, in essence, overpaid, because presumably the lowest priced winner will set the market price for the bond in the secondary market. • This creates an incentive for bidders to collude to lower prices.

18. Treasury Auctions • Dutch-Auction Method • Bidders again make bids specifying a yield and a quantity. • Treasury then begins awarding the bonds to the bidders with the lowest yield (highest price) until they exhaust the supply of bonds. • The highest yield that wins any of the bond is known as the stop-out yield. • All winning bidders pay the stop-out yield. Thus the most aggressive bidders do not pay any more than the least-aggressive winning bidder. Non-Competitive bidders also pay the stop-out yield. • There is not as much incentive to collude.

19. Treasury Auctions • At first it appears that Treasury would earn less in a Dutch auction, since the highest bidders wind up paying less than they were willing to pay. • If we were using the “first-price” method (where you pay what you bid), they would most likely adjust their prices downward, to try and minimize the “winners curse”. • The theory is that the “average” winning yield in a first-price auction might be lower than the stop-out yield in a Dutch auction.

20. Treasury Auction • The book has some real examples of auction results. • To fully illustrate the differences in the processes, however, we will look at a stylized example auction. • Let us assume that the Treasury is auctioning off $10 Billion in 30 Year Treasury notes, and that there 5 firms bidding for these bonds. • Let’s assume that each firm bids for the same quantity and price regardless of the type of auction used.

21. Treasury Auctions

22. Why Switch Systems? • It was not until about 1998 that the US Treasury adopted uniform-price auctions. What motivated this change? • Uniform-price (Dutch) auctions encourage more aggressive bids, and hence higher prices for the bonds sold (on average). • Evidence that the markup (profit) in the secondary market was smaller with the Dutch system– meaning that the Treasury was trying to capture more of the “surplus” that was otherwise going to the dealers. • Evidence that uniform-price auctions tended to encourage price-discovery prior to the auction, whereas the discriminatory system tended to encourage price-discovery after the auction. This evidence was in the form of the volatility (st. deviation) of mark-ups.

23. When-Issued Trading • Trading in a new issue of Treasury bonds will typically begin almost immediately after the Treasury announces that an auction will be held. • Prior to the settlement of the auction, the trading is done in what is known as the “When-issued” market. • This is purely a form of forward-contract trading. Participants are simply taking long and short positions prior to the securities actually becoming available. • This helps primary dealers determine what their demand is, and where to begin the bidding for the bonds in the auction.

24. When-Issued Trading • Note that settlement of when-issued trades occurs on a price-basis one day after the auction conducted. • One must be very cautious, therefore, of price data on Treasuries in the first day or so of their trading. A lot of the prices and volumes are actually not trades done on that day, but rather, are settlements of the “when issued” market. • This is a very important general issue for building financial models – you cannot rely strictly on data without really understanding what is happening in the market that generates the data.

25. Bidding Strategies • A securities dealer that bids on a US Treasury security is making a sizeable investment of resources. They must make sure that: • Their bid is reasonable, relative to the secondary market into which they wish to sell the security. • That they can hedge the interest rate risk exposure that they take on with the bid. • They can help do this by participating in the When-Issued market. • The WI market allows them to sell treasuries in a forward market – i.e. they sell the security before for the auction, with delivery set after the auction. • They can get a sense for where to set their auction bids based on this forward market.

26. Short Squeezes • Occasionally the when-issued market will have so much volume that dealers will not be able to cover short positions in the security, leading to a “short squeeze”. • Since the dealers have to deliver the specific security (unless substitution is allowed under their trade agreements), the price of those specific securities will become much higher than even other Treasuries with identical cash flows. This creates data problems for researchers! • When there is a short squeeze, one way dealers get more of the security is to borrow it via the repo market.

27. Short Squeezes • If the dealer borrows the security via the repo market, they give cash to the lender of the security in return for the security (which they use to cover their short position.) • They pay a “premium” by reducing the interest rate they charge on the cash they provide. This is called putting the repo on “special”. • For example, let’s assume you own two bonds, Bond A and Bond B, and that there is a short squeeze on Bond A. If you wanted to borrow cash via the repo market, and you put bond B up as collateral, you might have to pay interest of 1.5%, but because the dealer needs Bond A specifically, they might only charge you 1.0% if you put bond A up as collateral.

28. Salomon Brother Scandal • In the May, 1991 2-Year Treasury auction, Salomon apparently tried to corner the market. They acknowledged purchasing 44% of the issue, and regulators alleged that they may have had 85% of the issue. • If true, this calls into question the ability of the auctions to be fair to all players, but especially to the Treasury/taxpayers, and the other market participants. • It would also cast doubt on the integrity of the system. • In the end the government fined Salomon and instituted a few procedural changes to fix the problem.

29. Salomon Brothers Scandal • Please read (i.e. you are responsible for) the economic analysis that Sundaresan provides regarding this matter. • The general methods that he used to find evidence of the cornering of the market is very typical of economic research – there is not specific “smoking gun”, but rather, an accumulation of evidence that in the end becomes undeniable.