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Dutch auction has notable downsides, namely the free-rider problem. The way it's supposed to work is that a number of investors do due diligence, decide on the
by DenisM 10y ago
Dutch auction has notable downsides, namely the free-rider problem.
The way it's supposed to work is that a number of investors do due diligence, decide on the price they think it's worth it to them, and make their bids. Once enough pledges been made, the lowest price is given to all bidders.
However an investor may decide to join in without any effort put into due diligence. Instead he will decide to bid high and rely on others to set the fair price.
First, the "honest" investors end up paying for the free riders. Second, the free-riders end up crowding in and bidding up the price above the reasonable level. Consequently the "honest" investors put all the effort into it and end up with nothing to buy at their determined price. In the end "honest" investors end up not participating at all, so the Dutch auction thing just fell apart.
In short, smart money was in charge setting correct price, but smart money was crowded out by dumb money. This problem is not unique to Dutch auctions, but it appears that that's where it is the most acute.
- CobrastanJorji 10y agoCould you explain a bit more? I don't see how free riders are a problem. Anyone who's willing to pay an arbitrarily high price in order to get in on the stock should probably get some stock. If there are enough such actors, they'd significantly raise the sale price, but that's the point, isn't it?
- DenisM 10y agoTwo problems: 1. Suppose two funds compete, and the both partake in a Dutch auction. They end up with having the same stock at the same price at the dutch auction, and so the same income. However the free-rider gets fewer expenses so his profits are higher. The diligent fund is losing to the free rider in profits. After a while there are no more diligent funds. 2. The diligent fund prices stock at "proper" value, the free-rider prices it higher hoping to pay the lower, "proper" price but getting ahead of the diligent fund in the queue. If there are many free-riders they all end up in the queue before the diligent fund, so the latter may get less stock, or no stock at all. After a couple of such experiences the diligent funds stop partaking in any new Dutch auctions.
- alexkon 10y agoWhat if instead of a blind auction, a company conducts an open Dutch auction? That is, everyone can see the amount of stock sold so far and the price of each transaction (the buyers may remain anonymous). The prices different buyers pay are not necessarily the same: the first buyer pays the highest price, the late buyers pay less but risk having nothing at all if they wait too long. In an open auction, bidding too high just causes the buyer to lose some money.