Informational Advantage in US Treasury Auctions

Abstract

We extend Wilson (1979) share auction framework to model the uniform-price US Treasury auction as a two-stage multiple leader-follower game. We then explicitly derive the primary dealer’s (follower) strategic choice of bids as a function of its customer’s (leader) bids and show that an increase in a customer’s bid leads to two types of its dealer’s reaction – the quantity effect by which the primary dealer increases its quantity, and the price effect by which the primary dealer decreases its bid shading. We find that comparing to the direct bidding system, the primary dealer bidding system increases the competition, which leads to an increase in both Treasury revenue and revenue’s volatility. Relatively to existing studies, this paper first extends the left continuous step demand schedule in Kastl (2011) to explain how primary dealers move their bid-points around customers’. Second, it complements Hortacsu and Kastl (2012) by explicitly deriving the primary dealer’s strategic choice of bids as a functional of its customer’s bids and explaining how the primary dealer’s informational advantage impacts its bidding behavior in handling the risk of being short-squeezed or face the winner curse in the post-auction market. Third, it provides valuable insights along the bidder’s demand schedule that show that primary dealers bid more aggressively than other bidders, as opposed to Hortacsu, Kastl, and Zhang (2018).