Dutch auctions have been going on since at least the 16th century. Originally, a “Dutch auction” just meant a reverse auction where a single item would go up for bid at a very high price, with the price being steadily lowered by the auctioneer until someone raised their paddle to buy the item and finish the auction. Dutch auctions are still used once in a while in the collectibles or real estate markets.
As Dave Nadig, Director of Exchange Traded Funds for FactSet, notes in a recent report: “In financial markets, we use the term [Dutch auction] to refer to almost any configuration of rules that result in crossing a maximum volume of securities at a single price. The Treasury department uses a system like this to sell bonds. WR Hambrecht uses a similar system to price IPOs. The New York Stock Exchange uses it every day to open and close stocks.”
How NYSE uses Dutch auctions
The NYSE version of a Dutch auction collects all of the Market-on-Open and Limit orders together and determines the price at which the maximum number of shares will trade hands.
To explain, Nadig offers an example of 10,000 shares to sell at $10, and nobody has entered in a buy order for $10 or more. Since there is no natural crossing price, no auction occurs and any market orders are priced at the midpoint of the current National Best Bid/Offer.
However, with 10,000 shares to sell at $10, and someone has a buy order in for 5,000 shares at $11, then 5,000 shares could be sold anywhere between $10 and $11. The price of the cross will be set closest to the previous trade ($11 if the last trade was $12, or $10 if the last trade was $9).
Furthermore, any market orders will cross at that price, as long as there are enough buyers and sellers. Market orders are taken care of in the order that they were received, and all shares not traded are the “imbalance” and are simply not executed. Nadig notes this is pretty rare, as market makers typically place an order to offset “imbalances”.
Use Dutch auction process after trading halts to fix ETF problems
The Dutch auction process offers highly accurate price discovery. For a “fair” price for Citigroup on the open of a trading session, what could be more fair than the price on which the largest number of people agree?
The process is fair, and anyone asking too much or offering to little simply will not get their trade executed. It clearly makes more sense to have thousands of shares crossing to set the “opening” price than a competition to see who can get the first 100 share trade made.
Keep in mind that many more modern stock exchanges already use a formal Dutch Auction process to reopen a halted security. The BATS exchange runs a simple, clean process that will not allow a security to trade until all the market orders in the system can be executed at a common price (no matter the pricing bounds).
To avoid issues like the recent ETF problems with pricing, Nadig suggests a similar Dutch auction process for determining an opening price for ETFs when market “circuit-breakers” kick in. He says it should work something like this:
- During a halt, all order flow is directed to the listing exchange
- Exchanges use a common, pre-determined Dutch auction process
- Exchanges publish all order imbalances and proposed clearing prices during the halt
- Individual issues only reopen when all market orders can clear
- No trades by anyone until the security reopens on the listing exchange.