2013

MANAGERIAL ECONOMICS GROUP PROJECT: “US TREASURY BILLS AUCTION PRICING: ANALYSIS OF THE STRUCTURE AND PROCESSES” Professor:

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The goal of this paper was to analyze and explain the auction system process held by US Treasury and the possible alternatives for it (multiple-pricing auction). Introduction. The U.S. Treasury Department regularly borrows to finance the Federal Government's debt. From 1980 to 2006, the public debt of the United States grew from $930 billion to $8.68 trillion. Approximately one-half of that debt is held in Treasury bills, notes, and bonds, or "treasuries." The Treasury Department sells these securities at auctions held at the Federal Reserve Bank of New York, and the Bureau of Public Debt (BPD) in Washington, D.C. The rest of the debt is held mostly in federal and federally sponsored agency securities and U.S. Savings Bonds, and is not sold through the auction process.1 The modern auction process for bills, notes, and bonds begins with a public announcement by the Treasury. A typical announcement might read, "The Treasury will auction $11,000 million of 91-day bills to refund $9,000 million of maturing securities and to raise about $2,000 million new cash." This statement clearly describes the 2 goals of Treasury: to refund old debt and to raise new funds. Such announcement is carried by most major newspapers, the financial press, and some television stations. Bids are accepted up to thirty days in advance of the auction, and may be submitted electronically through the Treasury Automated Auction Processing System (TAAPS) and by mail. All bids are confidential and are kept sealed until the auction date. In an auction, two types of bids can be submitted: Non-competitive tenders and competitive bids. Non-competitive tenders are generally submitted by small investors and individuals. All non-competitive bidders are guaranteed to receive securities; they need only complete an application form and make payment by mail anytime before the normal 12:00 p.m. Eastern Time auction deadline. Noncompetitive bids submitted by mail must be postmarked by the auction and received by the date of the security. Competitive bids are usually submitted by primary dealers for their own accounts, or on behalf of customers. Bids are submitted in terms discount rate. To ensure that the secondary market for Treasury securities remains competitive, bidders are restricted to receiving no more than 35 percent of the total amount of securities available to the public. Many of the securities bought by large dealers will later be sold and resold on the secondary market to companies,

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Federal Reserve Bank of NY web-site: http://www.newyorkfed.org/aboutthefed/fedpoint/fed41.html

banks, other dealers, and individuals. Determination of winning bids. Officials at the Treasury Department subtract the non-competitive tenders (which automatically receive securities) from the public offering amount to determine the amount of securities available to the competitive bidders. For example, if $1 billion in non-competitive tenders is received in an $11 billion auction, $10 billion in securities will be awarded to competitive bidders. The Treasury officials work their way down the list of competitive bids, accepting the highest bid prices until all the securities have been awarded. All lower competitive bids are rejected. In the Treasury bill auction example below, securities would be awarded to the first four bidders only, whose bids total $12 billion. The two highest bidders would be awarded their total bid amounts, whereas the two bidders at the 5.10 percent discount rate would each receive $2 billion in securities. Treasury sells its securities to the public through single - price auctions, where both successful competitive bidders and noncompetitive bidders buy securities at a price that equals the highest accepted discount rate (for bills). The detailed list of accepted and rejected competitive bids is not released to the public, but the total amount of bids received and total accepted are made available. In addition, the high, low, and weighted averages of the price, discount rate, and equivalent bond yield of the accepted competitive bids are released to the public. (see also Application) Table 1. Example of Competitive Bidders.2 NAME Bidder 1 Bidder 2 Bidder 3 Bidder 4 Bidder 5 Bidder 6 BID PRICE $987.16 $987.13 $987.11 $987.11 $987.08 $987.06 DISCOUNT 5.08% 5.09% 5.10% 5.10% 5.11% 5.12% AMOUNT $3.5 billion $2.5 billion $3.0 billion $3.0 billion $2.0 billion $1.0 billion

In this example above, the final price applicable to both competitive and successful noncompetitve bidders would be 5,10%; non-competitive investors won't learn the yield on the

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http://www.newyorkfed.org/aboutthefed/fedpoint/fed41.html

securities they have purchased until after the auction. The final price, discount rate, and yield is released to the public within two hours of the auction. Such an unusual process of determination the competitive auction winners and also the fact that there are two different groups of bidders creates several interesting questions, that we tried to answer during our analysis. 1. Why not Treasury uses use different final bids prices (pure price discrimination)? The feature of a Treasury auction (the single-price format) was introduced in 1992. The change from the earlier multiple-price format was part of a major overhaul of the auction process that followed several violations of auction rules in 1991. The Treasury first adopted the multiple-price format when it initiated bill auctions in 1929 and it continued to use that format when it introduced auctions of coupon-bearing securities in the early 1970s. However, when the auction process came under scrutiny in 1991, public officials became interested in alternative formats that might appeal to more investors and that might lead to lower financing costs. In a single-price auction, a participant can bid its actual reservation yield for a new security, that is, the minimum yield at which it is willing to buy the security. The bidder certainly has no reason to bid a lower yield, but if the auction stops at a higher yield it will get the full benefit of buying at that higher yield. In contrast, the multipleprice format encourages a participant to bid higher than its reservation yield in hopes of getting the security on more favorable terms. Also, the question of choosing between these two auction formats had lead to empirical analysis that partially answered it. In September 1992, the Treasury announced that, in an experiment, it would begin to auction two-year notes and five-year notes in the single-price format3. It subsequently produced two empirical studies analyzing the results of the experiment. The results of this experiment were following: • For both single-price and multiple-price auctions—the difference between the auction yield of a security and the yield at which the same security was trading in the whenissued market at the time of the auction. A positive difference indicated that the securities had been auctioned at a yield higher than the one at which they were trading in the when-issued market. (the higher the yield – the more it costs Treasury

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http://www.newyorkfed.org/research/current_issues/ci11-2/box2.html

to issue debt). For securities auctioned in a multiple-price format, the average difference was statistically significantly greater than zero. For securities auctioned in a single-price format, however, the studies were unable to reject the hypothesis that the average difference was zero. These results suggest that moving to a single-price format would lead to lower financing costs. • The studies were unable to reject the hypothesis that changing auction formats would leave the average difference unchanged. This problem arose because the differences between auction yields and when-issued yields in single-price auctions were quite volatile. The studies could neither reject the hypothesis that the average difference in single-price auctions was different from zero, nor could they reject the hypothesis that the average difference was different from the (positive) average difference that characterized multiple-price auctions. • The studies examined whether single-price auctions reduced the concentration of auction awards. It was found that the single-price format did not materially affect the distribution of awards between dealers and others but that it did lead to a lower concentration of auction awards to the largest dealers. Consequently, by introducing single-price auctions (in addition to 35% bidding limit) Treasury increased the competition between investors during T-bill auctions. 2. Why Treasury uses competitive bidding? First of all we must say that Treasury auctions are designed to minimize the cost of financing the national debt by promoting broad, competitive bidding (aka “tender”) and liquid secondary market trading. The goal of Treasury debt management is to meet the financing needs of the Government at the lowest cost over time. Since Treasury auctions provide the principal means of financing deficit and refinancing maturing debt, Treasury officials have sought to structure the auction process to minimize the government's costs, both directly by promoting broad, competitive bidding and indirectly by promoting liquid post-auction secondary markets for new issues. Competitive bidding then, aims at obtaining goods and services at the lowest prices possible, by stimulating competition and by preventing favoritism. It can assume two forms:

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Open competitive tendering is where the invitation to tender is publicly available for all interested suppliers to respond. This method is most commonly used in governmental organizations. Closed competitive tendering is where the invitation to tender is issued to a predetermined, or restricted number of suppliers. Generally (and from a theoretical point of view) the advantages of competitive bidding

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and the reasons for its use are: • It promotes competition between suppliers, resulting in best "value for money" for purchasers and users. • • It offers a kind of transparency that helps mitigate favoritism and corruption In the case of open tendering, it gives all suppliers the opportunity to win the business that is advertised. Structure, rules and limitations: In the interest of fostering a liquid post-auction secondary market for a new issue, the Treasury limits the maximum auction award to a single bidder to 35 percent of the offering, less the bidder's “reportable net long position” in the security. A bidder's net long position is the sum (one-half hour before the close of bidding) of: • When-issued, forward, and futures contracts for the security and for principal STRIPS to be derived from the security (STRIPS—an acronym for Separate Trading of Registered Interest and Principal of Securities— are single-payment claims for the respective interest and principal payments from a coupon-bearing security) • The excess, if any, of its net holdings of previously issued securities with the same identifying number and STRIPS. The historical reason for such rules lies in the fact that with passing of time strategic bidding by some large auction market participants made competitive bidding riskier and more complicated for other participants. Bidders had to anticipate the likely volume of overbidding; if the expected overbidding did not materialize, they would end up owning more securities than they wanted. In the interest of encouraging broad public participation in its auctions, the Treasury decided, in the beginning of the ‘90s, to limit the total bids by a given participant at a given yield or discount rate to 35 percent of the amount offered to the public.

Why does the US Treasury allocate bills also through non-competitive bidding? In general, the advantages of non-competitive bidding can be summarized as: 1. It encourages wider participation and retail holding of Government securities. 2. It will enable individuals, firms and other mid segment investors who do not have the expertise to participate in the auctions. 3. Such investors will have a fair chance of assured allotments at the rate which emerges in the auction. Nonetheless, this procedure raises questions about whether deeper reasons exists why the Government allocates bills this way. Moreover, it is important to note that different countries differ in preferences about bills auction systems, e.g. The U.S. Treasury primarily uses noncompetitive tender, while Canada's central bank, the Bank of Canada, primarily uses competitive tender (but also accepts non-competitive bids), why is it? Another aspect to mention is that primary distributors (as defined above) can also choose to bid on behalf of smaller customers, and those who receive securities in the competitive tender process may then choose to sell them on the secondary market. It would appear that institutional investors taking part to competitive bidding hold a somewhat critical (and maybe too influential) position, blurring some of the immediate (and partial) answers that can be draw already from the advantages mentioned above about non-competitive tender, which basically lead to two kinds of effect: • Justice with respect to smaller or less informed investors. Smaller investors, in fact, can’t or don’t need to meet the minimum purchase requirement for competitive bidding. Moreover, they wouldn’t be able to compete with large institutional investors in the same auction. Further, non-competitive bidding is way simpler than the competitive one, since bidders don’t have to specify the return they want and they are guaranteed that their bid will be accepted and that they will get the full amount of the bill paid back. • Safety: risk of very high losses in competitive tender claims for an alternative formula to be available, so that small/medium investors can participate without taking the price risk in auctions. How the liquidity on the secondary market affects the pricing of T-bills? The way how liquidity affects the price of T-bills can be described by the notion of trading on a when issued basis, which occurs immediately after the announcement of the forthcoming auction. So that dealers and other market participants begin to trade the new

security on a when-issued basis. Secondary market transactions in outstanding Treasury securities typically settle on the business day after the trade date, when sellers deliver securities to buyers and receive payment. When-issued transactions, by contrast, settle on the issue date of the new security (which can be as much as a week or more after a trade is negotiated) because the security is not available for delivery at any earlier date. When-issued trading enables market participants to contract for the purchase and sale of a new security before the security has been auctioned. This type of trading is important because public dissemination of the yield at which a new note is trading, or the discount rate at which a new bill is trading, provides valuable information about the market's appraisal of the prospective value of the security. Officials pointed out that when-issued trading “reduces uncertainties surrounding Treasury auctions by serving as a price discovery mechanism. Potential . . . bidders look to when-issued trading levels as a market gauge of demand in determining how to bid at an auction”4. When-issued trading thus contributes to the Treasury's goal of promoting competitive auctions by enhancing market transparency. A particularly important part of pre-auction when-issued trading involves purchases by private investors from dealers. The purchases have two significant distributional effects. First, they facilitate distribution of a new issue ahead of its auction. Officials noted that when-issued trading “benefits the Treasury by . . . stretching out the actual distribution period for each issue, . . . allowing the market more time to absorb large issues without disruption”5. Second, whenissued sales by dealers to private investors leave the dealers with a need to make offsetting purchases in the auction, concentrating bidding interest in the hands of market participants that have a substantial financial incentive to identify correctly the price that balances demand with supply.

4 The Joint Report on the Government Securities Market (1992). By U.S. Department of the Treasury, the Securities and Exchange Commission, and the Board of Governors of the Federal Reserve System 5 The Joint Report on the Government Securities Market (1992). By U.S. Department of the Treasury, the Securities and Exchange Commission, and the Board of Governors of the Federal Reserve System

Chart 1. Uniform price at T-bill auction6
S
Price of T-­‐ bills

E2

D1

E1 (Final auc4on price)

Da

D2 Quan4ty of funds

First of all, on this graph, we determined supply function as a supply of T-bills, which represent the current auction. Secondly, the demand functions (D1 and D2) are the demand for T-bills by two group of investors: D1 is a demand only from non-competetive bidders. D2 is is the demand from only from competetive bidders. Da = D1 + D2 and so is an aggregate demand from both types of bidders for the T-bills supplied by Treasury. By analyzing this graph, we tried to answer several interesting questions: • Why the supply of T-bills (in the inverse manner, it is actually the Treasury’s demand for loanable funds) is not perfectly inealstic (or in other words, insensitive to interest rates) as it is stated in some books7? Actually, the answer on this question is relatively simple. The government needs funds for two reasons: to refinance it's current debt and to obtain new funds. Explanation held by the Madura textbook states that Federal government is interest-insensitive, or their demand for loanable funds is inelastic. However, in the real world such an assumption can not be treated as a real case as government also has several alternatives for obtaining loanable funds: by not only using the monetary policy actions of obtaining funds (printing money, seeking for public loanable funds (as T-bills)), but also by changing the fiscal policy mechanisms (increasing various tax-rates). This principle is complicating to explain in such a paper as it is not really

This graph is schematic as it is not based on the real data and may only represent the general picture of T-bill auction pricing process. 7 «Financial Markets and Institutions» by Jeff Madura, 9th edition, p. 32. 6

devoted to the problems of macro-economics, but we should say that government’s demand for loanable funds is for sure interest-sensitive and that is why it’s shape of demand curve for loanable funds has a negative slope (in our case we are analyzing the supply of T-bills curve – but they are actually the same things). • Why don’t the Treasury aggregate non-competitive bidders and competitive together (make a uniform auction for every bidder) and by doing so charge the E2 price for the T-bills and gain more money from the auction process? Why they use versioning? To answer such question we need to define the problem under two points of view: that of the bidders and that of the Treasury and under two orders of explanations: one based on economic considerations, the other on balance and fairness between bidders. The Treasury distinguishes between competitive and non-competitive in order to select among bidders; the big investors (generally institutions) can invest much more than the small ones. By creating a double-structure process, the Treasury ensures to raise funds from both kinds of bidders, while with a single auction some bidders (the small ones) would be excluded. In fact, non competitive bidding exists for investors who can't or don't wish to meet the minimum purchase requirements for competitive bidding on Treasury bills or notes. Moreover, by involving all the bidders in one auction, the final result for the Treasury would be a higher price to pay for its debts, since the yield to maturity for bidders would be higher, given that at the end of the auction the higher prices will be selected. The bidders, on their side, have “risk” as a main reason to participate in different auctions. A singular auction for all bidders would exclude the small ones, as we said, but even if the small ones were able to participate (e.g. in case the limitation of 5 million was cancelled) the risk they would be taking would be too high for a small or individual investor, also considering the fact that these are generally non-expert in the field. • Why is the demand from non-competitive bidders perfectly inelastic? The reason lies in the fact non-competitive bidding is a method of purchasing Treasury bills at the weekly public auction without having to submit a price. With a noncompetitive bid, the investor agrees to purchase a given amount of securities at the average price set at the end of the auction, reason why the quantity of T-bills doesn’t vary with the price established. Noncompetitive bidders only decide how much to invest, but quantity of T-bills and final price are only determined at the end of the auction. Basically, bidders agree to accept whatever interest

rate is decided at the auction. They are guaranteed that their bid will be accepted and that they will get the full amount of their bill paid back. But they won't know exactly what interest rate they will receive until the auction closes. All in all, we can say that the focus of this paper was to present the clear picture of how the T-bills auction process currently looks like and why the parts of this mechanism are structured in a way that exists today. Table of contents

1. http://edfriendly.blogspot.ru 2. http://www.treasurydirect.gov 3. «Financial Markets and Institutions» by Jeff Madura, 9th edition 4. The Joint Report on the Government Securities Market (1992). By U.S. Department of the Treasury, the Securities and Exchange Commission, and the Board of Governors of the Federal Reserve System 5. http://www.newyorkfed.org/aboutthefed/fedpoint/fed41.html 6. http://www.investopedia.com/articles/bonds/10/history-t-bill-auction.asp 7. http://money.howstuffworks.com/personal-finance/financial-planning/treasury-bills1.htm

Application This appliction gives clear picture of the recent auction process held by US Treasury. Upcoming Auctions Announcement Security Security Date Term Type 10-31-2013 91-DAY BILL 10-31-2013 182BILL DAY *11-04-2013 28-DAY BILL *11-06-2013 3-YEAR NOTE *11-06-2013 *11-06-2013 *11-07-2013 *11-07-2013 *11-07-2013 10YEAR 30YEAR 91-DAY 182DAY 364DAY NOTE BOND BILL BILL BILL CUSIP Nmber8 912796AR0 912796CK3 Auction Date 11.04.2013 11.04.2013 Issue Date 11.07.2013 11.07.2013 Maturity Date 02.06.2014 05.08.2014

912796BN8 11.05.2013 11.07.2013 912828WF3 11.12.2013 11-152013 912828WE6 11-1311-152013 2013 912810RD2 11-1411-152013 2013 912796BY4 11.12.2013 11-142013 912796CM9 11.12.2013 11-142013 912796CL1 11-1311-142013 2013

First, the US government will issue a notice indicating how much money it would like to borrow. Below is an actual announcement issued by the treasury department that it will be having an auction to raise $34 billion

CUSIP Number: An identification number assigned to all stocks and registered bonds. The Committee on Uniform Securities Identification Procedures (CUSIP) oversees the entire CUSIP system. 8

2013 Treasury Securities Auction Press Releases: 13-week Bills Treasury Offering Announcement (October 24, 2013) Term and Type of Security Security Description Offering Amount Currently Outstanding CUSIP Numbe Auction Date Original Issue Date Issue Date Maturity Date Maximum Award Maximum Recognized Bid at a Single Rate NLP Reporting Threshold NLP Exclusion Amount Minimum Bid Amount and Multiples Competitive Bid Rate Increments Maximum Noncompetitive Award Eligible for Holding in TreasuryDirect® Estimated Amount of Maturing Bills Held by the Public Maturing Date SOMA Holdings Maturing SOMA Amounts Included in Offering Amount FIMA Amounts Included in Offering Amount Noncompetitive Closing Time Competitive Closing Time

91-Day Bill 13-Week Bill $34,000,000,000 $25,001,000,000 912796BW8 October 28, 2013 August 01, 2013 October 31, 2013 January 30, 2014 $11,900,000,000 $11,900,000,000 $11,900,000,000 $8,800,000,000 $100 0.005% $5,000,000 Yes $89,000,000,000 October 31, 2013 $0 No Yes 11:00 a.m. ET 11:30 a.m. ET

The length of the borrowing for this particular auction is 91 day. The announcement indicates the date of the auction (October 28th, 2013) as well as deadlines for competitive (11:30 a.m. ET) and

noncompetitive (11:00 a.m. ET) bids. There is a limit of $5 million that can be submitted as a noncompetitive bid per bidder per auction. Once the auction is completed the treasury will post the results of the auction. Below is the one of the most actual results of the auction. Treasury Auction Results Term and Type of Security CUSIP Number High Rate9 Allotted at High10 Price11 Investment Rate Median Rate12 Low Rate13 Issue Date Maturity Date 91-Day Bill 912796BW8 0.045% 16.20% 99.988625 0.046% 0.035% 0.020% October 31, 2013 January 30, 2014

High Rate: This is the highest yield (or the lowest price) that was accepted at the auction. Allotted at High: This is the percentage of the total that was filled at the highest accepted yield (or lowest accepted price). 11 Price: Price as determined by the auction. 12 Median Rate: Half of the competitive bids were submitted below this rate while the other half were above. 13 Low Rate: The lowest yield (or highest price) submitted for the competitive bids. 10 9

The announcement also shows the breakdown of the amount of bids submitted noncompetitively versus competitively and how much was rewarded for those same categories. Tendered $130,933,585,000 $405,302,300 $804,500,000 $132,143,387,300 $0 $132,143,387,300 Tendered $114,750,000,000 $11,756,000,000 $4,427,585,000 $130,933,585,000 Accepted $32,791,385,000 $405,302,300 $804,500,000 $34,001,187,300 $0 $34,001,187,300 Accepted $25,273,600,000 $3,090,200,000 $4,427,585,000 $32,791,385,000

Competitive Noncompetitive FIMA (Noncompetitive) Subtotal SOMA14 Total

Primary Dealer Direct Bidder15 Indirect Bidder16 Total Competitive

SOMA. This stands for System Open Market Account. This represents treasuries that are held by the Federal Reserve (For our example auction the FED had no bills maturing at the time) Primary Dealers: A primary dealer is a bank that works with the FED to purchase government securities. A bank identified as a primary dealer is required to bid on US treasuries. In this way US treasury auctions are designed to never fail. 15 Direct Bidders: These are bidders who submitted bids directly. These can be individual investors, banks, or money managers. This usually represents domestic demand. 16 Indirect Bidders: These are bidders that bid on behalf of others. This is thought to represent foreign central banks and governments. This usually represent foreign demand of US treasuries. 14