Finance

Financial market design (without abstracts)

“The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response” (with Eric Budish and John Shim), Revise and Resubmit Quarterly Journal of Economics, December 2013. Winner of 2014 AQR Insight Award [Presentation; Policy: SEC Chair White, European Commission, NY Attorney GeneralCFTC Comment Letter; Press: EconomistBloomberg June 18 June 16 Feb 20, FT, WSJChicago Tribune, Atlantic Monthly; Panels: CFTC TAC]

“Implementation Details for Frequent Batch Auctions: Slowing Down Markets to the Blink of an Eye” (with Eric Budish and John Shim), American Economic Review P&P, 104:5, 418-424, May 2014.

“Common-Value Auctions with Liquidity Needs: An Experimental Test of a Troubled Assets Reverse Auction” (with Lawrence M. Ausubel, Emel Filiz-Ozbay, Nathaniel Higgins, Erkut Ozbay, and Andrew Stocking). In the Handbook of Market Design, Nir Vulkan, Alvin E. Roth, and Zvika Neeman (eds), Oxford University Press. Chapter 20, 489-554, 2013. [Presentation]

“A Two-Sided Auction for Legacy Loans” (with Lawrence M. Ausubel), University of Maryland, March 2009.

“Making Sense of the Aggregator Bank” (with Lawrence M. Ausubel), The Economists’ Voice, 6:3,  February 2009.

“No Substitute for the ‘P’-Word in Financial Rescue” (with Lawrence M. Ausubel), The Economists’ Voice, 6:2, February 2009.

“Auctions for Injecting Bank Capital” (with Lawrence M. Ausubel), Addendum to A Troubled Asset Reverse Auction, University of Maryland, October 2008.

“A Troubled Asset Reverse Auction” (with Lawrence M. Ausubel), Working Paper, University of Maryland, September 2008. [Presentation]

“Auction Design Critical for Rescue Plan” (with Lawrence M. Ausubel), The Economists’ Voice, 5:5, September 2008.

National media on financial rescue plan

Print: “Gaming the Financial System,” Newsweek, 18 November 2008. [pdf]

“Economists Look at Ways to Structure Auctions,” Wall Street Journal, 25 September 2008.

“Auctions May Be Only Option for U.S. Bailout,” Reuters, 22 September 2008.

Radio: “How about Taking Bids on Bad Assets?” National Public Radio Marketplace, 2 February 2009. [mp3]

“Study Suggests Buying Toxic Assets Could Work,” National Public Radio All Things Considered, 18 November 2008. [Transcript]

“Complicated Reverse Auction May Aid In Bailout,” National Public Radio Morning Edition, 10 October 2008.

TV: “Geithner to Unveil Financial Rescue Plan Monday,” PBS Nightly Business Report, 6 February 2009. [Transcript] [mp4]

“Will the Government Take Away the Toxicity on Bank Books?,” PBS Nightly Business Report, 29 January 2009. [Transcript] [mp4]

“What Price Should Fed Pay” CBS Evening News, 23 September 2008.

“Auctioning Securities,” (with Lawrence M. Ausubel) Working Paper, University of Maryland, March 1998.

“Auctions and Takeovers,” New Palgrave Dictionary of Economics and the Law, Peter Neuman (ed.), London: MacMillan Press, 1, 122-125, 1998.

“Relational Investing and Agency Theory,” (with Ian Ayres) Cardozo Law Review, 15, 1033–1066, 1994.

“Using Auction Theory to Inform Takeover Regulation,” (with Alan Schwartz) Journal of Law, Economics, and Organization, 7, 27–53, 1991.


Financial market design (with abstracts)

“The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response” (with Eric Budish and John Shim), Revise and Resubmit Quarterly Journal of Economics, December 2013. Winner of 2014 AQR Insight Award [Presentation; Policy: SEC Chair White, European Commission, NY Attorney GeneralCFTC Comment Letter; Press: EconomistBloomberg June 18 June 16 Feb 20, FT, WSJChicago Tribune, Atlantic Monthly; Panels: CFTC TAC]

We argue that the continuous limit order book is a flawed market design and propose that financial exchanges instead use frequent batch auctions: uniform-price sealed-bid double auctions conducted at frequent but discrete time intervals, e.g., every 1 second. Our argument has four parts. First, we use millisecond-level direct-feed data from exchanges to show that the continuous limit order book market design does not really “work” in continuous time: market correlations completely break down at high-frequency time horizons. Second, we show that this correlation breakdown creates frequent technical arbitrage opportunities, available to whomever is fastest, which in turn creates an arms race to exploit such opportunities. Third, we develop a simple new theory model motivated by these empirical facts. The model shows that the arms race is not only socially wasteful – a prisoner’s dilemma built directly into the market design – but moreover that its cost is ultimately borne by investors via wider spreads and thinner markets. Last, we show that frequent batch auctions eliminate the arms race, both because they reduce the value of tiny speed advantages and because they transform competition on speed into competition on price. Consequently, frequent batch auctions lead to narrower spreads, deeper markets, and increased social welfare.

“Implementation Details for Frequent Batch Auctions: Slowing Down Markets to the Blink of an Eye” (with Eric Budish and John Shim), American Economic Review P&P, 104:5, 418-424, May 2014.

Our recent research (Budish, Cramton and Shim, 2013) proposes frequent batch auctions – uniform-price sealed-bid double auctions conducted at frequent but discrete time intervals – as a market design alternative to continuous-time trading in financial markets. This short paper discusses the implementation details of frequent batch auctions. We outline the process flow for frequent batch auctions, discuss a modification to the market design that accommodates market fragmentation and Reg NMS, and discuss the engineering and economic considerations relevant for determining the batch interval. Open questions are discussed throughout. 

“Common-Value Auctions with Liquidity Needs: An Experimental Test of a Troubled Assets Reverse Auction” (with Lawrence M. Ausubel, Emel Filiz-Ozbay, Nathaniel Higgins, Erkut Ozbay, and Andrew Stocking). Forthcoming in the Handbook of Market Design, Zvika Neeman, Al Roth, and Nir Vulkan (eds), Oxford University Press. January 2013. [Presentation]

We report the results of an experimental test of alternative auction designs suitable for pricing and removing troubled assets from banks’ balance sheets as part of the financial rescue planned by the U.S. Department of Treasury in the fall of 2008. All auction mechanisms tested here are structured so that many individual securities or pools of securities are auctioned simultaneously. Securities that are widely held are purchased in auctions for individual securities; securities with concentrated ownership are purchased as pools of related securities. Each experimental subject represents a bank which has private information about its liquidity need and the true common value of each security. We study bidding behavior and performance of sealed-bid uniform-price auctions and dynamic clock auctions. The clock and sealed-bid auctions resulted in similar prices. However, the clock auctions resulted in substantially higher bank payoffs, since the dynamic auction enabled the banks to better manage their liquidity needs. The clock auctions also reduced bidder error. The experiments demonstrated the feasibility of quickly implementing simple and effective auction designs to help resolve the crisis.

“A Two-Sided Auction for Legacy Loans” (with Lawrence M. Ausubel), University of Maryland, March 2009.

On Monday, 23 March 2009, Treasury Secretary Geithner presented the Public-Private Investment Program as a key instrument to resolve the financial crisis (www.financialstability.gov). The Treasury’s description still leaves many issues unanswered. We flesh out the auction design for legacy loans. A two-sided auction is required. Both banks and private investors must compete in a transparent and competitive process.

“Making Sense of the Aggregator Bank” (with Lawrence M. Ausubel), The Economists’ Voice, 6:3, February 2009.

On Tuesday, 10 February 2009, Treasury Secretary Geithner proposed the aggregator bank (“public-private investment fund”) as a key instrument to resolve the financial crisis (www.financialstability.gov). The Treasury description leaves many issues unanswered. Here we explain how an aggregator bank might operate in practice. We fill in some of the major details so as to enhance the effectiveness of the aggregator bank. In particular, the approach emphasizes transparency and value to the taxpayer, minimizing the need for bank-by-bank negotiations and thereby minimizing the opportunities for the government to play favorites.

“No Substitute for the ‘P’-Word in Financial Rescue” (with Lawrence M. Ausubel), The Economists’ Voice, 6:2, February 2009.

Three months and three-hundred billion dollars of bank rescue efforts have gotten bogged down in a widespread and irrational fear among policymakers: the fear of trying to put a price on banks’ troubled assets. So profound is this fear that the Bush Treasury opted instead for the “suitcase approach,” where large sums of cash were delivered to banks (solvent and insolvent alike) with few strings attached. The government needs to restore the banking sector, while protecting the interests of taxpayers. There is no substitute for the P-word.

“Auctions for Injecting Bank Capital” (with Lawrence M. Ausubel), Addendum to A Troubled Asset Reverse Auction, University of Maryland, October 2008.

Public discussion has turned, in the past few days, toward using some of the $700 billion in rescue funds for the injection of government money into banks in return for ownership stakes. The purpose of this short note, an addendum to “A Troubled Asset Reverse Auction,” is to describe an auction mechanism suitable for injections of capital into banks. The auctions would price the equity purchases through a competitive process.

“A Troubled Asset Reverse Auction” (with Lawrence M. Ausubel), Working Paper, University of Maryland, September 2008. [Presentation]

The US Treasury has proposed purchasing $700 billion of troubled assets to restore liquidity and solve the current financial crisis, using market mechanisms such as reverse auctions where appropriate. This paper presents a high-level design for a troubled asset reverse auction and discusses the auction design issues. We assume that the key objectives of the auction are to: 1) provide a quick and effective means to purchase troubled assets and increase liquidity; 2) protect the taxpayer by yielding a price for assets related to their value; and 3) offer a transparent rules-based process that minimizes discretion and favoritism. We propose a two-part approach.

Part 1. Groups of related securities are purchased in simultaneous descending clock auctions. The auctions operate on a security-by-security basis to avoid adverse selection. To assure that the auction for each security is competitive, the demand for each security is capped at the total quantity offered by all but the largest three sellers. Demand bids from private buyers are also allowed. The simultaneous clock auctions protect the taxpayer by yielding a competitive price for each security and allow bidders to manage liquidity constraints and portfolio risk. The resulting price discovery also improves the liquidity of the securities that are not purchased in the auctions.

Part 2. Following Part 1, the remaining quantity is purchased in descending clock auctions in which many securities are pooled together. To minimize adverse selection, reference prices are calculated for each security from a model that includes all of the characteristics of each security including the market information revealed in the security-by-security auctions of Part 1. Bids in the pooled auctions are specified in terms of a percentage of the reference price for each security.

“Auction Design Critical for Rescue Plan” (with Lawrence M. Ausubel), The Economists’ Voice, 5:5, September 2008.

The Treasury proposes to invest $700 billion in mortgage-related securities to resolve the financial crisis, using market mechanisms such as reverse auctions to determine prices. A well-designed auction process can indeed be an effective tool for acquiring distressed assets at minimum cost to the taxpayer. However, a simplistic process could lead to higher cost and fewer securities purchased. It is critical for the auction process to be designed carefully.

National media on financial rescue plan

Print: “Gaming the Financial System,” Newsweek, 18 November 2008. [pdf]

“Economists Look at Ways to Structure Auctions,” Wall Street Journal, 25 September 2008.

“Auctions May Be Only Option for U.S. Bailout,” Reuters, 22 September 2008.

Radio: “How about Taking Bids on Bad Assets?” National Public Radio Marketplace, 2 February 2009. [mp3]

“Study Suggests Buying Toxic Assets Could Work,” National Public Radio All Things Considered, 18 November 2008. [Transcript]

“Complicated Reverse Auction May Aid In Bailout,” National Public Radio Morning Edition, 10 October 2008.

TV: “Geithner to Unveil Financial Rescue Plan Monday,” PBS Nightly Business Report, 6 February 2009. [Transcript] [mp4]

“Will the Government Take Away the Toxicity on Bank Books?,” PBS Nightly Business Report, 29 January 2009. [Transcript] [mp4]

“What Price Should Fed Pay” CBS Evening News, 23 September 2008.

“Auctioning Securities,” (with Lawrence M. Ausubel) Working Paper, University of Maryland, March 1998.

Treasury debt and other divisible securities are traditionally sold in either a pay-your-bid (discriminatory) auction or a uniform-price auction. We compare these auction formats with a Vickrey auction and also with two ascending-bid auctions. The Vickrey auction and the alternative ascending-bid auction (Ausubel 1996) have important theoretical advantages for sellers. In a setting without private information, these auctions achieve the maximal revenue as a unique equilibrium in dominant strategies. In contrast, the pay-your-bid, uniform-price, and standard ascending-bid auction admit a multiplicity of equilibria that yield low revenues for the seller. We show how these results extend to a setting where bidders have affiliated private information. Our results question the standard ways that securities are offered to the public.

“Auctions and Takeovers,” New Palgrave Dictionary of Economics and the Law, Peter Neuman (ed.), London: MacMillan Press, 1, 122-125, 1998.

Under Delaware law (the predominant corporate law in the US), when a potential acquirer makes a serious bid for a target, the target’s board of directors is required to act as would “auctioneers charged with getting the best price for the stock-holders at a sale of the company.” (Revlon v. MacAndrews & Forbes, 173). The target’s board may not use defensive tactics that destroy the auction process and must attempt to seek higher bids. Similarly, the Williams Act requires takeover bids to remain open for at least 20 business days on the grounds that the delay facilitates auctions. This preference for auctions follows from the view that auctions maximize shareholder returns. In addition, auctions promote efficiency by shifting corporate assets into the hands of those that value them most highly. And auctions mitigate the collective action problem of target shareholders by requiring the target board to seek the highest bid. Takeover auctions differ from traditional auctions in important respects. In a traditional auction, the seller describes what is being sold and states the auction rules in a public announcement. Takeover auctions are instead prompted by a potential buyer. Only after the buyer has expressed an interest in the target are bids from others sought. The process is governed not by a fixed set of auction rules specified by the seller, but rather by complex takeover regulations, which give the target board some latitude in the process. The process is typically not stated in advance, but evolves as bidders and bids arrive. For the most part, the regulations provide ways to defend against hostile takeovers with poison pills, greenmail, and other tactics. Despite these differences, to a first approximation takeovers are well modeled as an ascending-bid auction with significant participation costs. This essay begins by looking at takeover auctions from the point of view of a buyer, focusing on bidding strategy. Then strategies of the target are discussed. Finally, the desirability of takeover auctions is addressed.

“Relational Investing and Agency Theory,” (with Ian Ayres) Cardozo Law Review, 15, 1033–1066, 1994.

This Article analyzes how, and when, corporate governance could be improved by utilizing “relational investing.” The term relational investing is just coming into vogue and there does not yet seem to be a consensus on what it means. Although the term has been trumpeted on the cover of Business Week, before the Conference on Relational Investing at Columbia University, relatively little legal writing had been published on the subject. For the purposes of this Article, we define relational investing to encompass commitments to buy and hold significant blocks of a corporation’s stock. And it is particularly important that the relational investors commit not to tender their shares to hostile bidders. Using our definition, relational investing is used to foreclose or reduce hostile takeover threats, replacing this form of external discipline with enhanced internal discipline by the relational investors. The long-term investment induces the relational shareholders to invest more in acquiring information about the effectiveness of management. To be effective internal monitors, however, relational investors must be able to use this information to influence corporate policy. At a minimum, relational investors must be “provocable” — they must be able to increase the likelihood that poor management or poor policies will be changed. Relational investors might accomplish these changes through either internal (informal negotiation or proxy contest) or external (tender offer) means. Although we will often assume that relational investors are committed to patient oversight, it is important to remember that these commitments are usually noncontractual, suggesting that an implicit commitment to buy and hold stock must be self-enforcing. This self-enforcement constraint might be especially useful in determining when relational investing is likely to arise. For example, the short-term illiquidity of large blocks of stock might make the buy and hold commitment more credible. Moreover, large block holders often will lack an incentive to reduce the size of their holdings. The 13(d) filing requirements of the Securities Exchange Act could also facilitate relational investing, because unfulfilled representations to buy and hold stock can give rise to legal liability. Using the minimalist definition that relational investors commit not to tender a large block of shares, it is possible that relational investing could reduce agency costs by providing a more effective form of corporate governance. This is far different from arguing that, as an empirical matter, relational investing is superior to more traditional forms of corporate governance. Indeed, some theorists suggest that with “friendly” relational investing, there is a substantial risk of entrenched managers and exacerbated agency costs. Without adjudicating the ultimate efficacy of relational investing, our analysis illuminates how relational investing might create value and highlights the contexts in which it is most likely to be effective. We generate three main conclusions from our analysis of relational investing: First, relational investing can reduce agency costs, both by increasing the principal’s incentive to acquire information, and by improving the principal’s ability to foster a monitoring reputation through a long-term relationship with the firm’s management. Large block holders have a greater incentive to monitor than do “rationally ignorant” atomistic shareholders. In addition, the commitment to hold for long periods of time permits relational investors to enter more credibly into self-enforcing implicit contracts that discipline poor managerial decisions and abilities. Second, relational investing may be better suited to mitigating “moral hazard” problems than traditional types of monitoring. In particular, potential third-party bidders are less likely to respond to problems of moral hazard than to problems of adverse selection. Even in a strong form efficient capital market, external monitors may not have an adequate incentive to discipline managers who have succumbed to moral hazard and caused the corporation to bear an inefficient sunk cost. Relational investors, in contrast, have a multiperiod incentive to respond. Third, relational investing can be rationalized by either of the following theories: (1) the threat that managers will lose their jobs is minimal; or (2) managers face too great a threat of losing their jobs.

“Using Auction Theory to Inform Takeover Regulation,” (with Alan Schwartz) Journal of Law, Economics, and Organization, 7, 27–53, 1991.

This paper focuses on certain mechanisms that govern the sale of corporate assets. Under Delaware law, when a potential acquirer makes a serious bid for a target, the target’s Board of Directors is required to act as would “auctioneers charged with getting the best price for the stock-holders at a sale of the company.’’ The Delaware courts’ preference for auctions follows from two premises. First, a firm’s managers should maximize the value of their shareholders’ investment in the company. Second, auctions maximize shareholder returns. The two premises together imply that a target’s board should conduct an auction when at least two firms would bid sums that are nontrivially above the target’s prebid market price.