Lets walkthrough a basic approach of IPO / ICO using Dutch Auction mechanism and on why its been adopted widely in the blockchain space.
The name “Dutch auction” dates back to 17th century Holland, when this method was used to improve the efficiency of the Dutch tulip market auctions.
What is Dutch Auction ?
A Dutch auction, usually refers to a type of auction in which an auctioneer starts with a very fairly high price, subsequently lowering the price until someone places a bid. The first bid wins the auction (assuming the price is above the marked reserve price). This mechanism helps in avoiding bidding wars, which is in case with other auction mechanism, where the price starts low and then rises as multiple bidders compete to be the successful buyer.
Dutch Auction IPO/ICO
A slightly different variant of the Dutch auction are employed by the financial markets. The price of the offering here is determined after taking in all bids. The highest price at which the total offering can be sold is then determined based on the bids and this price may not necessarily be the highest bid price. Dutch auctions can be used to sell Treasury securities, IPOs, floating-rate debt instruments, and other securities.
Lets suppose a company is using a Dutch auction as their mechanism for IPO (say 2000 shares), investors start entering their best bids with the number of shares they want to purchase along with the respective price they are willing to pay for each share. For example, an investor(A) may place a bid for 100 stock shares at $10 for each share, while another investor offers to buy 1900 shares at $5 for each share.
Once all the bids are submitted, the bidders are placed in a descending manner, starting from the highest bids. The shares are then allocated to the investors as per their bid order, until all the shares are allocated. However, the price that each bidder pays is based on the lowest price of essentially the last successful bid. Therefore, even though investor(A) bid $10 for his each share, since the last successful bid is $5, he now has to pay only $5 for his each share.
Confusing isn't it 🤪, Let’s try to understand the mechanism more deeply with workflow and examples
Auction Workflow:
- A Company announces total number of shares they are willing to sell in the IPO / ICO.
- Potential Investors / Bidder submit their best bid.
- The Bids are placed from high to low (usually in a way profitable to the company) starting from the highest bids .
- The cutoff-price is then determined.
Cutoff-Price is the price at which the last successful bid order is executed. It is generally taken as the accepted price of the share. - Investors are then allocated their shares at the cutoff-price. The investors need to pay only the accepted cutoff-price for each share, instead of their quoted amount per share.
Example #1:
Let, Company XYZ want to sell 500 shares
Bidding Scenario:
- Investor A bids for 200 shares at $7 / share
- Investor B bids for 150 shares at $15 / share
- Investor C bids for 250 shares at $5 / share
- Investor D bids for 50 shares at $20 / share
- Investor E bids for 50 shares at $25 / share
- Investor F bids for 250 shares at $10 / share
Sorted Bid Placements:
Total Remaining Shares initially = 500
- Investor E bids for 50 shares at $25 / share. (Remaining shares = 450 )
- Investor D bids for 50 shares at $20 / share. (Remaining shares = 400 )
- Investor B bids for 150 shares at $15 / share. (Remaining shares = 250 )
- Investor F bids for 250 shares at $10 / share. (Remaining shares = 0 )
Shares Allotments:
Since Our last accepted bid is at 10$, here our cutoff-price = $10
- Investor E is allotted 50 shares at $10 / share
- Investor D is allotted 50 shares at $10 / share
- Investor B is allotted 150 shares at $10 / share
- Investor F is allotted 250 shares at $10 / share
Lets look into another similar Example , but this time with a different bidding scenario.
Example #2:
Let, Company XYZ want to sell 500 shares
Bidding Scenario :
- Investor A bids for 200 shares at $10 / share
- Investor B bids for 150 shares at $15 / share
- Investor C bids for 250 shares at $5 / share
- Investor D bids for 50 shares at $20 / share
- Investor E bids for 50 shares at $25 / share
- Investor F bids for 250 shares at $10 / share
Sorted Bid Placements:
Total Remaining Shares initially = 500
- Investor E bids for 50 shares at $25 / share. (Remaining shares = 450 )
- Investor D bids for 50 shares at $20 / share. (Remaining shares = 400 )
- Investor B bids for 150 shares at $15 / share. (Remaining shares = 250 )
- Investor F bids for 250 shares at $10 / share.
- Investor A bids for 200 shares at $10 / share.
Shares Allotments:
Since Our last accepted bid is at 10$, here our cutoff-price = $10
Here, Investor F and Investor A , bid for the same share price. But, we cannot accept both the bid orders as we have only 250 shares left. Then how do we proceed with the share allocation… ?
Although there are multiple solution that can be formulated as per the business logic. One of the most common solution is by the usage of Allocation ratio.
Allocation_Ratio = Total_Available_shares / Total_Requested_Shares
Here, Total Available shares from the company is 500 shares ,
but Total shares requested by bidding is 700 shares ( 50 + 50 + 150 + 250 + 200).
Therefore we need to allocate 700 share requests within the available 500 shares.
Thus, Allocation ratio = 500 / 700 = 0.71
So, if a user had bid for 1 share , he would be allocated only 0.71 share
Allotted_Share = No of shares bid by user * Allocation_Ratio
Therefore,
- Investor E is allotted 35.5 shares (50 * 0.71 = 35.5)
- Investor D is allotted 35.5 shares (50 * 0.71 = 35.5)
- Investor B is allotted 106.5 shares (150 * 0.71 = 106.5)
- Investor F is allotted 177.5 shares (250 * 0.71 = 177.5)
- Investor A is allotted 142 shares (200 * 0.71 = 142)
Thus we have allocated 700 share requests from the available 500 shares, using the approach of allocation ratio, With each share priced at $10 (cutoff-price)
Note: The decimals in allocation ratio can be increased as per the required precision
Advantages of Dutch Auction:
- More benefit to the company and helps in price discovery.
- Allows even small scale investors to participate.
- More Transparency in the process
- Eliminates Bid wars and make the process smooth.
- Faster than traditional Auction.
- Fetches better price than expected.
Disadvantages of Dutch Auction:
- At time investors tend to overspend than required due to uncertainty.
Since Investors are intended to bid their best bid, they many times tend to overbid. The high bid price which benefits the company, is a major disadvantage to the investor (winner regret). - Bidders are more likely to experience winner regret, which occurs when winners believe they overpaid and loser regret, which occurs when losers believe they underbid when participating in Dutch auctions compared to other types of auctions.
- Price volatility.
- No potential control over the price.
Dutch Auction in Blockchain ..???
Compared to Traditional Auction, there are very less transactions required for a dutch auction, which makes it tailor-made for blockchain. By adopting this auction mechanism, we need not spend unwanted gas fees on multiple bids, thus it becomes a better option to execute auctions in blockchain.
Conclusion
Dutch Auction proves to be a game changer as far as price discovery and profit to the company is considered. Companies many at times underprice their share values during the IPO/ICO, and post sale they see the prices to be pumped up. These kind of issues of price discovery seem to be solved easily using dutch auction mechanism.
Creators Note: More To Come
Hope, this explanation about Dutch Auction gave you a basic idea of how this mechanism works.
In the upcoming articles lets look into similar extensions of Dutch Auction, which profit both the company and the investor to some extent.
Also we will implement the same in blockchain using smart contracts.
Thank you so much for reading. If any queries, feel free to reach out to me on twitter, LinkedIn , Email.
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