Though Dutch auctions regularly appear in the crypto space and are frequently mentioned on Epicenter, it occurred to me that I only had a superficial understanding of their mechanics. Here's my attempt at explaining how they work in simple terms.
What is a Dutch auction?
Dutch Auctions date to the 17th-century flower market and are sometimes referred to as uniform price auctions. In this type of auction, bidding starts at a high selling price and decreases over time. With each price decrement, buyers place bids for the quantity (or volume) they wish to purchase.
With each round of bidding, a buyer has the opportunity to place a bid at a new lower price. However, buyers are encouraged to place their bids early as the action could end at any point.
A practical example of a Dutch auction
Let's use tulips bulbs as an example. A seller places 400 bulbs in a Dutch auction and sets the starting price at $2 per bulbs. The auction will begin at 10 am, and the price will decrease by $0.10 every 10 minutes.
- The auction starts at 10 am. No one bids as $2 is deemed too high a price.
- Alice bids 1.90$ on 100 bulbs at 10:10.
- Bob bids $1.80 on 50 bulbs at 10:20.
- Charlie bids $1.70 on 200 bulbs at 10:30.
- David bids $1.60 on 50 bulbs at 10:40.
The auction ends and all four participants get the final price of $1.60 per bulb. The seller pockets $640 and everyone is happy. ? Except for Erin – she was also in the auction and waiting for the price to reach $1.50 to place a bid on 150 bulbs. Unfortunately, she was outbid by David. ?
Let's imagine a different scenario in which David chooses not to bid at $1.60, leaving Erin the opportunity to place her bid.
Erin places her $1.50 bid for 150 bulbs! But this puts the total quantity above what is being offered by the seller. We need to find a way to satisfy each buyers bid. ? One way to do this is to allocate proportionate to the total amount. 400 bulbs is 80% of 500 bulbs. Each buyer would receive 80% of their bid quantity for $1.50 per bulbs. In this case, the seller pockets $600.
As we have seen, every decreasing bid forces buyers to name their price early or risk losing to a lower buyer.
How are Dutch auctions different from regular auctions?
Dutch auctions are different from traditional auctions in which bids of increasing value are made until which time a final selling price is reached. Otherwise known as English Auctions, traditional auctions are useful for items sold individually, or as lots to a single buyer (a car, piece of furniture, livestock, etc.)
Though Dutch actions are not widely used, they are more prevalent in markets where the goods or services sold are divisible, such as commodities, stocks or currencies.
In 2004, Google famously offered the shares in its IPO to investors in a Dutch auction.