January 22, 2014

Why Auctions Work

Did you know that auctioneers make bad grocery-store clerks?

So argues a GEICO TV commercial – unwittingly teaching a last lesson on high-frequency trading. I’m sure you’re ready to move on!

Ever see the movie The Red Violin? It traces a storied musical instrument through hundreds of years of handling by varied humans in different cultural steppes while interspersing scenes from the hushed confines of a high-end auction room a la Sotheby’s. There, the approved bidders are assembled hoping desperately to own it. We cut away, vignettes building to a climactic conclusion in the auction room. The bidding begins.

In auctions if you bid, you only buy if you’re the last bidder. In the stock market you get to buy when you’re the first.

In the GEICO ad, one customer outbids the other for groceries and nods with satisfaction. In the Red Violin, emotions embedded in ancestry and history push bids for the instrument ever higher. But only one party walks away with the case. It’s not a recent movie but if you’ve not seen it I won’t spoil the ending.

From movies and stocks we sweep west, panning across the high desert along the Oregon-Idaho border where the Snake River bottomlands are fertile ground for fruit orchards and sugar beets and potatoes grown by Ore-Ida for McDonald’s restaurants around the world.

Looking east from Oregon across the river – you’d need a brand-inspection slip if you were trucking cattle to it – was the local livestock auction market (it’s gone now and the parcel is vacant save for faded remains of a bygone era). You longtime readers will remember.

The auction operator would try to help his customers, beef suppliers like my father, by grouping animals in the ring. A uniform set of steers could bring a higher price from bidders, the cattle buyers from Simplot, Swift, Armour, Conagra. A buyer might try to split off an animal that looked different, which earned less per pound and peeved my father. Only approved buyers could bid. And the last bid bought the product.

We come back to high-frequency trading. In the stock market, you know neither the buyers nor the sellers, only their agents the brokers and oftentimes not even that. There’s no approved list (that’s what dark pools offer – a club requiring approval for entry). And the first bidder sets the price for any amount of 100 shares or more.

If the red violin in the movie were a share of stock, it would sell in pieces spread over the room, with bits of its strings priced one way and parts of the chin rest another. If cattle traded like stocks, you could race in and buy an ear, setting the price for steaks to come still live on the hoof. It would be utter chaos. No seller of violins would tolerate it and no vendor of livestock would use such a system.

Shares, steers and fiddles are different things, but public companies should examine the structure of the market that serves them and their consumers, the investors. We’ve accepted that the market is “better.” Cattle buyers and violin sellers I think would just shake their heads.

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