On the Paulson US Treasury Reverse Auction Process

Assuming the mooted auction does go ahead here are some thoughts as to possible designs.

The US Govt has a lot of experience in forward auctions selling treasury bonds as described here: http://www.newyorkfed.org/aboutthefed/fedpoint/fed41.html. If you have the time, Kenneth Garbade’s history of the treasury auctions is well worth a read - he emphasises the responses to failure as well as the successes in building a solid programme of auctions: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=596966.

For readers who are used to reverse English auctions the US Treasury format is very different from what you might expect. It is a single-round auction. As a bidder you put in one bid up until the deadline. This bid can state a price you wish to pay and how much you will buy at that price, or it can state a quantity you wish to buy at whatever the average price is. The Treasury then allocates the available bonds across the bidders based on who is offering the highest prices.

I expect that the US Treasury would want to use something similar in the proposed reverse auction. But things are not going to be as simple as that. There is some good debate amongst people who know auctions:

• Jason Busch and Sam Kinney discuss the level of optimisation functionality that could be used http://www.spendmatters.com/index.cfm/2008/9/29/Treasurys-700-Billion-Sourcing-Challenge–Is-it-Reverse-Auction-Time.
• NERA have produced a paper contrasting the existing Treasury Bill forward auction process with a potential reverse auction process here: http://www.nera.com/image/Buying_the_Bad_Stuff_Paulson_0908.pdf.
• Sam Kinney - co-founder of FreeMarkets (who pioneered the whole reverse auction space that TradingPartners is now a dominant player in) has some good thoughts here: http://www.uptheeconomy.com/?p=28

On one level the actual design of the auction is of secondary importance. Simple agreement on a bailout plan will be sufficient to soothe many nerves.

But once they start the reverse auctions will be the subjects of intense media and market scrutiny, at least in the early stages. So reverse auctions at the outset will need to be kept very simple. For this reason any real-time complex optimisation will need to be ruled out. At least to start with.

NERA point out in their paper (link above) a good issue: In a procurement reverse auction the buyer would likely only buy from one (or perhaps two or three, but certainly not all) of the bidders in the auction. So the bidders have to compete against each other to push the price down. Under the Paulson plan, if the government is committing to buying all the securities from all the banks (until the money runs out) then what is the incentive for any bidder to place a low bid? They know that the government will bail them out. To avoid this the auction process could include a number of bidders but commit the Treasury to buying securities from a small number of the bidders, or to buy a fraction of the auctioned value, such that all bidders have an incentive to bid.

There is also the question of one-round or multiple-round bidding. The US Govt currently sells Treasury bonds with one round of bidding so I’m sure they will be tempted to use a similar design for the bailout. But given the uncertainty around the value of the assets in question now I would expect the transparency of multiple-round bidding will be better. Paul Klemperer has some great horror stories of single-round bidding events. Search for “Banespa” and “New Zealand” in the document. The Banespa case was a first-price sealed bid auction, the New Zealand case was a second-price sealed bid auction (Vickrey auction). Both led to great embarrassment.

So could an auction work in this US bailout? It’s certainly well known across government and private sectors that auctions are the best way to ascertain a market price when the true market price is not known. I have seen some very successful reverse auctions for pension funds, for example. So perhaps using reverse auctions for mortgage-backed assets is not such a crazy idea after all.

On balance I think a long, regular series of auctions based on a multiple-round descending clock auction design with the government only buying a fraction of the securities on offer in each auction would be a good way to start the process. Then as the purchases become more commonplace, the desperate sellers offload their assets and prices creep up the government could look to add in optimisation technology.

Reverse Auction Guidelines from Purchasing.com

Purchasing ran an article some time ago providing guidelines on running electronic reverse auctions.

They make 7 points presented as questions and answers that buyers should take into account when figuring whether to run a reverse auction. Here are the 7 points:

1. The more competition the better
2. Do your supplier qualification before the event – protect yourself from having fly-by-night bidders offer an attractive price that then turns out to be unsustainable
3. Make the spend in the reverse auction as large as possible to make the reverse auction as interesting as possible for your suppliers
4. Make sure your specs are clear and watertight
5. Beware of running reverse auctions where a strategic relationship with your supplier is important (reverse auctions may damage supplier relationships)
6. Reverse auctions can offer a range of benefits in addition to (or instead of) lower prices e.g. faster sourcing times, a clear audit trail
7. Make sure you factor in all non-price parameters as numerical values into your auction

It is a great article and I just want to add a few comments/clarifications from my perspective.

Point 1: The more competition the better. I do agree with this – and generally I would like to see 4 suppliers in a reverse English auction. But bear in mind that in 2008 the auction industry now has more experience across a range of auction designs that can be particularly useful where have limited competition. In particular I am thinking of the successes I have seen with reverse Japanese auctions.

Point 5: Your ability to gain the benefits of a reverse auction, and still have a strategic relationship with your supplier, depends on how well you manage the process and not on whether you include a reverse auction or not. New suppliers are usually happy to win business through a reverse auction. Incumbents are usually unhappy having to compete with anyone to retain your business (whether through a reverse auction or whether simply through any traditional offline mechanism). In my own personal experience I can say that I have got a great relationship with the software development company that I selected via a reverse auction.

Point 7: I still see very many buyers shying away from incorporating non-price factors into their auctions. The good news is that there are nowadays robust methodologies in place to make doing this easier for you than would have been the case even 5 years ago.

More Reverse Auction momentum

Some more recent reverse auction stories that popped into my Google Reader:

Using Reverse Auctions to buy advertising spots on Radio. A quote:

Bid4Spots allows the media buyers (that’s us) to set a maximum bid and allow stations to bid ever-lower media prices. After all, the stations are selling next week’s leftover airtime.

The real power of Bid4Spots is the steadily lessening of price rather than the gradual increase. In a Bear economy, when most businesses are cutting their media spend, there exists a real opportunity for small and medium-sized businesses to get a lot of airtime for their money.

City of Waco uses a reverse auction to buy electricity. There seems to be a lot of interest in running reverse auctions for electricity these days. A quote:

“We’ve been wanting to try a reverse auction for some time, as we believed the process could significantly benefit the City and, ultimately, our taxpayers,” said Danny Jackson, Administrative Engineer, City of Waco. “I can’t say enough about how great World Energy’s people were throughout the process. The market directors were extremely knowledgeable about the industry and helped us make key decisions regarding structuring the auctions to ensure we had significant supplier participation. We were particularly pleased that World Energy was able to drum up supplier interest for the auction, even though we used our own paper for awarding the contract.”

 

2 points on this:

1. The Bid4Spots story is spot on in linking an upswing in reverse auction interest to the current downwards trajectory in the economy. This is what happened last time round in 2002.
2. The Waco story is spot on in highlighting the importance of market making support in running a successful auction. It’s no good these days for software companies to sell only software and/or software integration/implementation services. These days successful technology delivery revolves around what What Max Bleyleben (Disclosure: he works for Kennet, an investor in TradingPartners) calls software/services/content convergence. 

Unite Members to Protest Against Council Tendering

See here.

Unite, Scotland’s largest trade union, will hold a demonstration [Wednesday, 4th June] outside South Lanarkshire Council offices in protest at the blind bidding process for the care and support services for adults with learning disabilities.

South Lanarkshire Council set up an e-auction for firms to tender for providing care at home by submitting charges by the hour.

Thus begins the press release. Looks like an e-auction is the root cause of the antipathy.

Well - look again, further down.

Bidders were given no information in the tender document on the current terms and conditions of the employees who would be transferred.

In other words: the union’s issue seems to be with the quality (or lack) of information that was given out to bidders rather than with the bidding process itself. Once again - to run a good sourcing process (whether it involves an e-auction or not) you still need to be clear with suppliers. And make sure they have full access to the information they need to place sensible bids.

 

 

Reverse Auctions in the news

See  here .

Local government and schools are hoping to join forces to cut what each unit spends on millions of sheets of paper each year.
Rick Morrisey, purchasing manager for Lafayette, is working to arrange a bulk paper purchasing contract along with the county, Ivy Tech Community College and possibly others.

Despite rising paper prices Morrisey believes that by going through a spend aggregation exercise and then running a reverse auction on the aggregated spend that he will be able to achieve valuable savings.

Assuming he runs his auction process well I’m sure he will, and I wish him all the best in his project. Reverse auctions aren’t 5-minute jobs but when run well they tend to blow away people’s expectations.

Gearing up for more reverse auctions in 2008

This is from Supply Management in May. A quote from John Paterson, VP & CPO at IBM:

Sellers are more aggressive in their terms and pricing as they desire to maintain capacity and revenue streams. Sharp buyers recognise this and will typically look to place more business up for bid, take actions to renegotiate contracts, and seek out new suppliers. As always buyers should recognise markets change over time and they should do nothing that will damage their buying position when it becomes a sellers’ market again.

In these sorts of conditions reverse auctions are a great tool because they are able to cut through long-held assumed market prices and uncover exactly where suppliers are willing to go. But note John’s sage advice about not abusing market power. Again, reverse auctions, done well, are a good foundation on which to build solid supplier relationships (this has certainly been the case for me).

 

Auction confusion

Here are some items that popped into my google alerts recently for reverse auction:

• A lowest unique bid wins gambling site. Their press release appears to be deliberately confusing given that talks about reverse auctions, procurement auctions and e-sourcing before diving into their  gambling piece. They even go so far as to claim that “The legality of low unique auctions has been proven by the American, British and the Danish governments who are all using the low unique auction concept [for awarding procurement contracts].” (No they’re not, they’re using reverse auctions - they aren’t using gambling sites)
• Forwards Dutch Auctions for mobile gear

I know some of you will consider this is just me quibbling over semantics but this is pretty important. Surely buyers need to know their auction types to be able to run effective sourcing projects. Just like they need to know their DDP from their FOB. I get really riled when people use the same term to mean completely different auction types. How many buyers would know that this auction here is not a reverse auction at all but is a forwards dutch auction?

How many suppliers should I have in a reverse auction?

A few years back we did some work with Oxford University. They were interested in how procurement auctions fitted into the bigger auction picture. We were interested in finding out how in line with auction theory we were. I was looking through my old material from that study and I want to share a neat graph from that work that models how expected savings rise the more suppliers you include in an auction.

 

If you assume that all suppliers in a marketplace have a price evenly distributed between a low price and a high price then, on average, the savings you would get increase as shown in the graphic above. This helps emphasise that 4 bidders is a good number for a reverse English auction, as I have often said. But one thing to clarify: this is a model - you can do better than the model by ensuring that when you select potential suppliers that you are selecting suppliers who have a lower price rather than selecting suppliers at random from the marketplace.

Auctions: Seeing is Believing

Saw this post on Ariba’s blog about online reverse auctions. Good news that they are shining light back onto reverse auctions. Some comments:

Having budget stakeholders watch their potential suppliers competing for their business in an auction is a very powerful way to help sell the process internally. It’s a much easier concept for people to grasp if they see the results - better terms and/or lower costs - happening right before their eyes, with all the drama of a ticking clock.

Couldn’t agree more. And if you want to see a real auction (as opposed to a canned demo), TradingPartners regularly runs “viewing rooms” at which you are welcome to come and see for yourself a real auction. Clearly it won’t be your budget that’s being auctioned. But nevertheless seeing a reverse auction playing out in front of your eyes - and just imagining that it could be your company’s money you are saving - is the only way to really understand the power of the tool. If you are interested check the news pages on www.tradingpartners.com. And when you are running your own auction program it is very important to get stakeholders in to see the auction on auction day. It’s the best way, certainly that I’ve seen, of encouraging more reverse auction usage.

Disclosure: Yes, I work for TradingPartners (see the About page).

The poor, misunderstood reverse auction

Reverse auctions as we we know them today started in the mid 90s. So now seems about the right time for them to be going through their poor, misunderstood phase.

Tim Cummins writes a great analysis of how buyers reap what they sow: screw your suppliers when times are good and you can’t expect your suppliers to queue up and looking for win-win opportunities when the markets move against you.

Two years ago, IACCM was warning its members that the change was coming and that suppliers were shifting their loyalties - for example, they were investing their marketing dollars in emerging markets, rather than their traditional (disloyal) customers.. We alerted buyers to the fact that they would pay a price for alienating the supply base. But the good times rolled on - commoditization, reverse auctions, confrontational contract terms - these were just some of the ways that buyers showed their lack of loyalty to the traditional supply base in their haste to grab low prices and exert their dominance.

A timely warning, and nothing contentious, you might think. But now read the paragraph again and see how “reverse auction” is equated with “showing disloyalty to your suppliers”.

This is to put the cart before the horse. It’s (short-sighted) buyers who screw suppliers, not reverse auctions. And don’t forget that short-sighted buyers are able to screw suppliers with all kinds of methods: you certainly don’t need an auction to demonstrate disloyalty to your suppliers. You can screw a supplier perfectly well using certain contract clauses - but that is not to say that contracts are a bad idea.

From my own experience: I recently awarded a contract for software development services via a reverse auction. I have a good relationship with both the current and previous supplier. I believe this is because I was open and up front during the whole process (including explaining to the incumbent why I was going to market). The reverse auction in fact helped the decision making process be more transparent. And the contract was far easier to implement than would have been the case without an auction.

In that example the reverse auction helped both with achieving the right price and with helping build the supplier relationship.