Designing auctions to improve central bank operations
Submitting InstitutionUniversity of Oxford
Unit of AssessmentEconomics and Econometrics
Summary Impact TypeEconomic
Research Subject Area(s)
Economics: Economic Theory, Applied Economics
Commerce, Management, Tourism and Services: Banking, Finance and Investment
Summary of the impact
The banking crisis that followed the collapse of Northern Rock in 2007
resulted in an urgent need to inject liquidity into the financial system.
In order to resolve these issues, the Bank of England asked Professor
Klemperer, an expert in auction theory, to help re-dseign its long-term
market operations to allow the Bank of England to auction loans backed by
financial collateral of varying quality. Since 2010, this has been adopted
as the Bank of England's standard mechanism for its long-term repurchase
operations. The potential impact of the new auction design extends beyond
the Bank of England to other central banks, private industry and to
Professor Klemperer joined the Oxford University as Lecturer in Economics
in 1985, and was appointed to his current position of Edgeworth Professor
of Economics in 1995.
A large part of Professor Klemperer's research over many years has
focused on auction theory, and the insights that it provides for our
understanding of the operation of market economies. His earlier work
focused on the benefits of competitive auctions as a mechanism for sale
and procurement [section 3, R2, R3]; the problems inherent in
multi-unit, multi-product auctions including issues of collusion and the
fact that the seller has to decide how much to sell before she knows the
prices (section 3, refs 1 and 5). This research played a major role in the
design of the auction for British 3G Telecom licenses in 2000 [R1].
Building on this earlier work, Professor Klemperer's recent research
addresses the fundamental problem of how to sell goods that both sellers
and buyers view as imperfect substitutes when, as in the financial
context, multi-round auctions are impractical [R6]. His proposed
solution permits different but related goods to be traded and individually
priced in a single auction. Each bidder can make one or more bids, and each
bid contains a set of mutually exclusive offers. Each offer
specifies a price for a quantity of a specific "variety". The auctioneer
looks at all the bids and then selects a price for each "variety". The
idea is that the menu of mutually exclusive bids allows each bidder to
approximate a demand function, so bidders can, in effect, decide how much
of each variety to buy after seeing the prices chosen. Meanwhile
the auctioneer can look at demand before choosing the prices.
Importantly, offers for each variety provide a competitive discipline on
the offers for the other varieties, because they are all being auctioned
The `product-mix' auction is best understood as a "proxy" version of a
`simultaneous multiple round auction' (SMRA). Bidders input their
preferences, and the auction chooses the outcome that an SMRA would select
assuming straightforward bidding. Because the auction is "sealed bid", it
runs instantaneously (important in the financial-market context), and
therefore is less vulnerable to collusion. Another novel feature is that
while standard SMRA implementations specify the number of each type of
each good to be sold in advance, in the new `product-mix' auction the
auctioneer also bids its preferences about how the proportions of
different varieties that it will sell will depend upob the auction prices
( the overall supply constraint). The product-mix auction yields better
"matching" between suppliers and demanders, reduced market power, greater
volume and liquidity, and therefore also improved efficiency, revenue, and
quality of information than feasible alternatives.
References to the research
R2] Bulow, J and P. Klemperer (1996), `Auctions vs. Negotiations'
American Economic Review, 86, 1. pp 180-194, March.
R5] Klemperer, P. (2004) Auctions: Theory and Practice,
Princeton University Press, Princeton: US.
American Economic Review is a "top-5" world leading
general-interest journal. It is classed as "AAA" in the Combes-Linnemer
(2010) ranking. The AER was rated as "4*" by the ESRC-RES review of UK
Economic Journal is a leading general-interest journal; it is the
UK's top economics journal. It is classed as "AA" in the Combes-Linnemer
(2010) ranking. The EJ was rated as "4*" by the ESRC-RES review of UK
Journal of the European Economic Association is a leading
general-interest journal. It is classed as "AA" in the Combes-Linnemer
(2010) ranking. The JEEA was rated as "4*" by the ESRC-RES review of UK
Journal of Economic Perspectives is a leading general-interest
journal that focuses on research with a strong policy dimension. It is
classed as "A" in the Combes-Linnemer (2010) ranking.
* denotes publication returned as part of RAE 2008
** denotes publication returned as part of REF 2014
Details of the impact
The collapse of Northern Rock in 2007 gave rise to an urgent need to
inject liquidity into the financial system. Given this, the Bank of
England was willing to accept a wider-than-usual range of collateral
against loans, but it wanted a correspondingly higher interest rate
against any weaker collateral that it accepted. The Bank's existing
mechanisms for injecting liquidity into the markets raised a number of
significant operational issues (See Fisher et al (2011) for further
details -[section 5, C5]). To resolve these issues, the Bank of
England consulted Professor Klemperer, a leading researcher in auction
theory who had played a major role in the design of the auction for the
British 3G telecom licenses in 2000 [C5, p.4 and C6, p.9].
Professor Klemperer's `product mix' auction, described in section 2,
directly addresses the Bank of England's problem. In the context of
long-term repo operations, the `bidders' in the product-mix auction are
the Bank's counterparties, the `differentiated products' or `product
varieties' correspond to loans of central bank reserves that the Bank
makes against the narrow or the wider collateral set. The prices at which
counterparties bid are expressed as a spread (in basis points) to Bank
Rate (subject to a minimum spread of zero). The `overall supply
constraint' is the pre-announced quantity of central bank reserves that
the Bank is willing to supply through the auction.
The product-mix auction meets the Bank's objectives of:
- Allowing a broader range of collateral;
- Charging different interest rates for the loans depending on the
quality of the collateral in order to reduce moral hazard;
- Allowing market conditions, as revealed by the bids, to determine both
the interest rate premium for inferior collateral and the proportion of
inferior collateral accepted; and
- Permitting borrowers to specify how the collateral they supply will
depend on the auction outcome.
In 2010, the new auction was adopted as the Bank's standard mechanism for
long-term repo operations [C1, C2, C3]. The considerable
advantages of Klemperer's new auction over earlier mechanisms are set out
in a recent Bank of England paper [C5]. Expressing the bids as
spreads to Bank Rate (with a minimum spread of zero) eliminates the
interest rate risk arising from unexpected movements in the spread of
market rates to Bank Rate. Moreover, the spread that the Bank charges to
lend against weaker collateral is determined within the auction - as the
market becomes more stressed, counterparties are willing to pay more to
borrow against weaker collateral - and so the Bank no longer has to make a
judgment about the appropriate spread to charge counterparties. As market
stress increases, and the spread between the rates on wider
collateral-backed and narrow collateral-backed loans widens, the auction
design automatically allows the range of collateral accepted to increase.
As a result, the Bank of England is better able to manage the liquidity of
the financial system, particularly during periods of stress. A review of
the performance of the new auction design after one year of operation
concluded that "based on the operations to date, the Bank is satisfied
that the operational framework meets the objectives of the ILTRs" [C5,
The auction design is highly innovative in the field of central banking,
and was a first of its kind in any field. Commenting in a magazine article
in 2010, Paul Fisher, Executive Director, Markets and Member of the
Monetary Policy Committee noted "`the Bank's Indexed Long-Term Repo
[auctions] represent a world first in central banking...This is
potentially a major step forward in practical policies to support
financial stability" [C10, p.14]. In a speech in March 2011, Paul
Fisher observed "the academic profession can make a significant
contribution to the field of central bank operations. In this paper I have
highlighted one example in particular where our thinking has benefitted
considerably from such insight" [C6, p.15]. More recently, The
Bank's Governor, Sir Mervyn King, observed "The Bank of England's use of
Klemperer auctions in our liquidity insurance operations is a marvellous
application of theoretical economics to a practical problem of vital
importance to financial markets." [C4].
The product-mix auction design has potential to be used in a wide range
of contexts: for instance Klemperer and several other auction theorists
suggested that the US government use this form of auction to buy up "toxic
assets" from troubled banks in 2008. In the event the US government
changed direction and decided not to buy troubled assets after all.
Looking outside financial markets, other potential applications include
auctions for electricity transmission networks [C7, pp.14-15]; for
planning permission on brown-field v. green-field sites [C9].
Sources to corroborate the impact
C1] Bank of England (2010a), "The Bank's new indexed long-term
repo operation", Bank of England Quarterly Bulletin, Q2, p 90-91.
C2] Bank of England (2010b), "Bank of England position paper:
proposed framework for permanent long-term repo operations", March, 23rd.
C3] Bank of England (2010c), "Bank of England market notice:
Sterling Monetary framework indexed long-term repo operations" October 3rd.
C4] Economist (2012) "The golden age of micro", October 19th
C5] Fisher, P., Frost, T and O. Weeken (2011), " Pricing central
bank liquidity through product-mix auctions - the first anniversary of the
Bank of England's indexed long-term repo operations", mimeo Bank of
C6] Fisher, P. (2011) "Recent developments in the sterling
monetary framework", Speech given to Manchester Economics Seminar,
University of Manchester, 30 March
C7] Greve, T and M. G. Pollitt (2012), "Designing electricity
transmission auctions: an introduction to the relevant literature" Electricity
Policy Research Group Working Paper 1221, October 2012.
C8] Guardian, (2013) "How geometry came to the rescue
during the banking crisis", Newton Channel, Editors Choice, July 13th.
C9] Harford, T. (2011). "Why banks are going to auction", Financial
Times, April 9th http://www.ft.com/cms/s/2/5f8c0aea-5fec-11e0-a718-00144feab49a.html#axzz1J0Y9ASpE
C10] Milnes, A ( 2010), "Creating confidence in cash", Oxford
Blueprint, October 2010, p. 14.