Transparency & Auctions:
Bid up, Bid up and play the game
ISF MAGAZINE
September 2004 - Features
Securities lending auctions have been applauded for delivering immediate income to lenders and rewarding bidders with exclusive borrowing rights. John Piccitto compares the benefits and drawbacks of open and sealed-bid auctions, and examines some of the systems on offer.
Part of the power of financial industry auctions derives from the view that they will increase transparency. This is widely believed to be a Good Thing, if not for a particular buyer or seller, then for the market as a whole. Sometimes, this perception is articulated before or after the observation that a rising tide lifts all boats. Whilst auctions do provide transparency for some participants, some types of auction benefit only specific classes of participants. The trick is to find the right auction for the right product at the right time.
The initial use of auctions in the securities lending industry had two important outcomes for the lender. Firstly, it provided immediate income (upfront money, guaranteed income) for its securities. Secondly, the auction allowed the owner of a pool of securities to find a remunerative use for GC issues that otherwise might have languished unproductively in a custodial account. Large broker/dealers can always use GC shares for collateral, freeing up other shares for other uses, although they may need the inducement of also getting some hot stocks along with the CG issues rather like brightly-coloured prizes in cereal boxes.
Deceptive benefit
The determination of the highest market price available on the day is the essence of transparency. To use the 1995 Barclays Bank Aquila Fund auction as an example, a market price was learned, appropriate bidders found and the exclusive use of the portfolio awarded. However, the benefit to the lender of getting that immediate income can be deceptive - securities that are put out on loan for a specified period of time may actually have earned more had they been retained by their owner and loaned out later when they became hot, a lesson that Barclays learned to its sorrow.
However, there is now a web-based service available from Data Explorers in London (www.dataexplorers.co.uk) that determines this very point. The companys PerformanceExplorer service compares an auctions known generated income with the opportunity cost or benefit result of having loaned the same issues through alternative means, such as through a custodian, a third party lender, or an in-house arrangement.
According to Mark Faulkner, chief executive of Data Explorers, Used in this manner, the service enables the user to answer for themselves the question: Did my choice of an auction route to market achieve the highest return to lendable that could have been expected from this particular portfolio? Or to put it another way, did my choice generate or destroy securities lending alpha?
One selects a bid at auction based on the best available information at that time and effectively writes an option to the borrower. However, the true value of that option only becomes apparent over time. Whether one feels as happy with the value extracted at the end of the auction period as one does when awarding the business is critical when evaluating the auction process and determining whether to do it again or not. Our service provides clients with that retrospective capability, he says.
Like many of its successors, the first Aquila Fund auction followed a sealed or closed bid format - the seller knew as the bids came in who was bidding what, but the bidders didnt. In a closed bid auction, the bidders submit a sealed bid that they may change during the auction process, but the results of which they do not know until the auction is over. So a sealed-bid auction does not operate to provide transparency for the bidders, who fly blind, making the best reasonable bid(s) they can, and hoping for the best.
Heated bidding
Of course thats not how ordinary auctions charity auctions, or auctions for fine art operate. In open auctions, bidding can become quite heated - the price goes up as egos clash and caution is thrown to the wind. However, while such sport certainly has its place, the auctioning of securities is an altogether more sober affair. Still, something may be learned from the open auction model.
Is it possible for the owner to get a higher price for the security or portfolio on offer in an auction where the bidders at least know the price out against them? And is it not possible that a buyer who wants a portfolio might bid somewhat more aggressively, and thus successfully, in an open auction, as a direct result of the transparency of that model of auction? In an open auction, where everybody knows what is the highest bid on the table at any given moment, the bidder can improve their bid, within the range they have calculated to be appropriate, to win the auction. In a blind auction, they cant. The difference in profits to the seller/lender could be considerable; the difference to the borrower might be significant as well.
Herd instinct among bidders at an open auction is much discussed among auction theorists: how does the knowledge of what other bidders are doing affect the auction? The bidder at an open auction at which only the current bid is known (and not the identity of the bidders) cant take any clues from the other bidders, except that if the current bid is low, then they can lower their own sights. And if its high, then they must either stretch their own reserves or drop out of the competition. So that kind of open auction isnt much of a threat to a seller/lenders realistic expectations they can always set a reserve price and it provides the buyer/borrower with flexibility and control that they dont have in a sealed-bid auction.
This prospect and its outcome isnt going to delight a lender who may have exaggerated hopes for auction results, but as auctions become more common, narrow bidding spreads have become the norm. Bids that are far outside that range can quickly be identified, although what the seller chooses to do about it varies a lot. One large pension fund insisted that a large brokerage firm honour a sealed bid with an obviously misplaced decimal point: Youre big boys, you play by the rules, the lender thundered righteously, pouncing on his short-term advantage. Another smaller, more civilised investment fund phoned up an anomalous bidder to inquire whether or not he had considered the tax implications of his bid. The bidder gulped and asked if he could retract his bid. Of course you may, the fund manager said. Thats why we called you.
Closed bid auctions
Since some of the auctions available in the current market are run on a closed bid basis, it is worth looking at why this is so and whether or not there is any reason to do things differently. The sealed bid auction operates effectively for several reasons. For one thing, it protects a risk-averse seller (lender) from the predations of manipulative or collusive bidders. Put baldly, if a potential buyer doesnt know who the other bidders are or what theyre bidding, he can hardly collude with them to keep the bidding low or for other nefarious purposes. Also, the sealed bid auction can save the public face of a lender who has been unable to get sufficient bidders to come to an auction, or to entice them with the quality of the portfolio on offer to bid past the portfolio owners reserve price.
Getting a sufficient number of appropriate bidders to come to an auction is crucial to the profitability. And setting up a portfolio that is attractive to sophisticated bidders is a fine art. On the basis of pre-auction information, bidders calculate the near-term desirability of shares on offer. By contrast, an open bid auction enables the bidder who may have low-balled their bid to increase it in order to win a portfolio. This option establishes what is in fact the best price on the day, and it gets the goods to the buyer who is willing to pay the best price, clearly a boon to the seller. Rules of the auction, set up and accepted before the event, can still stipulate that the sellers decision is final, thus allowing the lender to deal with any credit and risk problems that may arise.
A sealed-bid auction provides no transparency at all for the borrower during the auction. However, before the auction and subject to the rules (posted by the auctioneer and agreed to by vetted bidders) the goods are described in detail, and every bidder has access to the same information. Thus the buyer has to decide before the auction an exact amount to bid, while in an open bid auction, they can vary their position to compete with other bidders.
In an open auction the winner knows immediately that they have won. In a sealed-bid auction, the winners may not be known for some time, making it more difficult to bid on complementary (or dissonant, for that matter) lots. It seems reasonable that if one of the major contributing factors to the success of an auction is getting enough qualified bidders to enter the auction, it is very important to make them comfortable once they get there. And making their task easier is a good start. This is an especially relevant as bidders become more experienced, as auctions become more frequent, and as margins shrink.
Optimal transparency in lending and borrowing securities is found in the operation of SecFinex, whose member groups have access to lists of securities available for borrowing at various price levels. Both borrower and lender need only view what is on offer and make a decision to borrow, loan or counter accordingly. The system is anonymous pre-trade with counterparties only discovering who is on the other side once the trade is done.
To enable this to work, the system manages the agreements and credit lines only allowing counterparties with sufficient limit to complete a trade. However, everybody sees all bids and offers in the system. If its no deal at the posted level, the borrower can make a counter-offer, or the lender can reduce the price, or sit tight until the stock gets hotter and the borrowers become more eager.
Auctions old and new
As the idea of auctioning securities becomes more popular, everybody is getting in on the act. ABN Amro Mellons iBid has run an open auction on single issues for many years. Savvy investment fund managers have found that it is easier to phone up your five best borrowers than to wait till they call you, or to work through a service provider. And third party lending programmes now in the development stage include an auction capacity in their plans.
SPF Beheer BV in the Netherlands has auctioned assets since 1999. Hans van Roekel, head of securities lending, manages a portfolio of securities for the Dutch Railway Pension Fund and the Pension Fund for Public Transport (with a total value of approximately j12 billion). Van Roekel began securities lending auctions with around 12 to 15 borrowers. Initially, he conducted open auctions - bidders entered their bids and knew what the highest price was as the auction proceeded. However, as time passed, SPF Beheer changed its format, reduced to four or five the number of bidders invited to submit prices, and switched to a more or less closed system. It turned out that every time the same names turned up as the highest bidders in the process, van Roekel explained.
In its current form, bids submitted to SPF Beheer BV are sealed. Once all bids are reviewed and other internal considerations are taken into account, the assets are awarded. Control of the bidding process in strictly maintained by SPF Beheer BV; the highest bidder is not necessarily the one awarded the securities, as the bidders track record on time deliveries, or prompt payment of dividends, for example is also considered. Once the securities are awarded, SPF Beheer BV notifies all bidders and tells them who won and why.
As the number of auctions increases, two things seem likely to happen. First, the spreads will narrow, so costs/profits will go down. Bidders have always been fairly sophisticated about the price range appropriate to a particular lot. The more auctions there are, the cannier bidders (and lenders) will become, squeezing margins tightly. But this is very unlikely to reduce the number of auctions, because auctions move GC issues in a way that does not seem to happen otherwise.
Secondly, within the context of narrowing spreads, the needs of borrowers may become increasingly important, in recognition of the fact that besides preventing collusion, getting a decent number of qualified bidders to an auction is central to profitability. And the bidders need for transparency may well surpass the lenders need for protection that is catered to by the sealed bid auction process.
Auctions and the upfront income they provide to lenders are very attractive, but spreads may well diminish even in a market in which hedge funds show a voracious appetite for stocks. Also, in a bull market lenders may wish to hold back their hot stocks with a view to generating greater income from them as the market rises. In this context, an open auction might better suit bidders, whose interests may become more important to lenders. And the interests of risk-averse lenders might be better represented in this circumstance by a custodian rather than by the lenders themselves.
Of course, transparency does not always reveal good news. The recent Alibris IPO revealed that nobody really wanted to buy the company at any price. Badly constructed portfolios have gone begging at auctions, and lenders have refused to award assets because they calculate that more money can be made by lending out the shares individually than by accepting any of the bids on offer. However, the openness of an auction and the increasing volumes passing through such systems cannot help but provide greater market liquidity and thus contribute to the growth of the equity finance business.
