Implications of Auction Theory for New Issues Markets

Imagine attempting to explain to a visitor, from another era or another planet, the economic rationale behind various institutions in the American economy at the start of the 21st century. Few practices seem more difficult to justify to the outsider than the current procedure for the issuance of equity securities. The share price in initial public offerings (IPO’s) often bears little connection to the equating of supply and demand, so that IPO’s are sometimes massively oversubscribed and the share price increases by as much as a factor of five from the offering price to the close of the first day of trading. Shares in these oversubscribed offerings are rationed, not according to willingness to pay, but to favored clients of the underwriting investment banks. Often there is at least the appearance that clients receive their allotments in exchange for returning value to the investment banks in other transactions; and recently there have been allegations that some allotments have been made in exchange for agreements to buy additional shares on the open market after the IPO. While the associated returns foregone by the sellers (i.e., the companies going public) would be easier to justify if the explicit fees for the service were commensurately discounted, the explicit fees charged for IPO’s actually seem quite high, generally a 7% commission on proceeds from the new shares. The main objective of this paper is not to hammer away at the inefficiencies present in the current system of new equity issuance; nor to attempt to explain what prevents the current system from being swept aside. Rather, this paper seeks to draw from new developments in market design—both theoretical results and new practices in other sectors—and to highlight alternative procedures that may be best suited to supplement or replace the current flawed system.