What is a Dutch Auction?

Unlike the typical auction where the highest bidder wins, a Dutch Auction starts with the highest price and decreases over time. This type of auction, also known as a “decreasing price auction” or “reverse auction,” involves the bidding price of the item decreasing from high to low until the first bidder accepts the price (reaching or exceeding the reserve price), at which point the auction is concluded with a hammer strike.

Historical Background of Dutch Auctions

The Dutch auction originated in 1887 when a bumper cauliflower harvest in the Netherlands led to an oversupply. To quickly address the surplus and minimize losses from spoilage, a grower invented the descending price auction, which differs from the traditional ascending price auction. As trading volume increased and technology advanced, auction clocks were introduced in 1906 for conducting transactions. Eventually, electronic dials were adopted for silent auctions.

How Do Dutch Auctions Work?

The process of a modern Dutch auction is as follows:

1. Sellers transport their items to the auction market. After undergoing quality inspection and information entry, the items are brought into the auction hall by a trolley in a randomly assigned order. Information such as the product name, quantity, quality, supplier, and minimum purchase quantity is displayed on the auction clock.
2. The auctioneer announces the starting price on behalf of the seller, and it gradually decreases from high to low. When a bidder accepts the price by pressing a button, the cursor stops moving. The final transaction price is the point where the cursor stops.
3. Next, the bidder informs the auctioneer of the desired quantity via a microphone. The auctioneer inputs this information into a computer, which calculates if the bid price multiplied by the desired quantity is less than or equal to the bidder’s pre-deposited transaction deposit. If this condition is met, the transaction is completed. If not, the computer reduces the bidder’s purchase quantity to prevent overdrafts.
4. If there is any remaining stock after the first bidder’s purchase, the auction restarts and continues until all items are sold or no one places a bid (resulting in an unsold item). The next batch of items is then auctioned, and this cycle repeats until the auction concludes.
5. During the entire auction process, the auction clock and the trolley carrying the items move in sync.

In practice, most Dutch auctions combine both ascending and descending bidding methods, which is why they are often referred to as “hybrid auctions.” Dutch auctions have a wide range of applications, commonly used in bond and stock auctions, as well as for bulk perishable goods. Items like bulk flowers and crops are frequently auctioned using this method.

Pros and Cons of Dutch Auctions

The Dutch auction method allows for a very fast transaction process. The auction is mechanized and electronic, which significantly speeds up the transactions.

However, the drawback of descending price auctions is that they come with relatively high transaction costs and lower efficiency (both in terms of capital and time). During the price reduction process, bidders often wait and watch, hoping for further price drops, which can result in a less competitive atmosphere.

Dutch Auctions in Web3

Dutch auctions are well-suited for the Web3 world. Blockchain projects like Algorand, Solana, and the gaming guild Yield Guild Game use Dutch auctions for their token issuance. Notable NFT projects such as Azuki and World of Women also use this method.

Dutch auctions address several problems associated with asset issuance in the crypto space. Popular token launches often involve a large number of participants, which can congest the network and result in many failed transactions, costing users Gas Fees. Moreover, when projects use liquidity pools or open sales, some users deploy scripts or modify RPCs to obtain tokens faster. This can leave regular users unable to get tokens or force them to buy at significantly higher prices.

Dutch auctions start with a high price that gradually decreases over time, putting all users on an equal footing. If users want to acquire the token, they can either bid at a lower price along with others or secure it at a higher price immediately. This bidding process makes it easier to reach a consensus on the asset’s value.

Further Development of Dutch Auctions

Liquidity Bootstrapping Pool (LBP)

A Liquidity Bootstrapping Pool (LBP) is a DeFi method used to ensure fair and decentralized distribution of new tokens. The LBP uses a pricing mechanism similar to a Dutch auction, where the initial price is set at the highest point and decreases over time. When using an LBP, projects do not need to deposit tokens and fundraising tokens in a 1:1 ratio. Due to the high initial pricing of a Dutch auction, they can often deposit fundraising tokens at a 1:10, 1:20, or even lower ratio, thereby reducing the issuance cost of the project’s tokens.

For a deeper understanding of LBP, check out the article Comprehensive Guide to Liquidity Bootstrapping Pool (LBP) and Participation Strategies.

Gradual Dutch Auction (GDA)

A Gradual Dutch Auction (GDA) is an auction mechanism designed to facilitate the public sale of assets with low liquidity. It enables the effective circulation and sale of these assets without depending on existing market liquidity.

The GDA works by breaking a single auction into a series of Dutch auctions, allowing participants to engage in multiple auctions at once. GDAs can be categorized into non-continuous GDAs and continuous GDAs.

Non-continuous GDA

Non-continuous GDAs are particularly well-suited for NFT sales because these assets need to be sold in whole units. The idea is to conduct a virtual Dutch auction for each individual NFT. In a non-continuous GDA, all auctions begin simultaneously, and each independent virtual auction has a higher starting price. The price for each auction is determined by a pricing function, which factors in the order of the auction within the series and the elapsed time since the auctions began.

For example, let’s say Alice wants to sell 10,000 NFTs. She’s unsure of their fair market value, so she avoids setting a fixed price. Instead, she might opt for a Dutch auction—starting with a high asking price and gradually lowering it until all the NFTs are sold. However, this approach might not be ideal because the market might not have enough buyers to absorb all the NFTs in one go.

On the other hand, if Alice auctions one NFT at a time, it could be more effective. For instance, she might start a new Dutch auction every minute, selling one of her new pieces. This approach gives the market more time to establish a fair price for her NFT artworks.

Continuous GDA

Continuous GDAs are ideal for token auctions. They work by gradually offering more assets for sale at a constant rate. The auction process is divided into a series of virtual auctions, each starting at a consistent price over time.

For example, Alice may not want to sell all her tokens immediately. Instead, she prefers to release them at a steady rate of 360 tokens per day. She can opt to sell her tokens through a series of standard Dutch auctions rather than a single GDA. For instance, she might hold an auction for 15 tokens every hour or 0.25 tokens every minute. The key to continuous GDA is minimizing the time intervals between auctions, making them almost continuous. This approach divides the sale into an infinite series of auctions, each offering a very small number of tokens.

Conclusion

Dutch auctions, an ancient method, have found new life in the modern era through their integration with computers, particularly in finance and bulk agricultural product auctions. In the Web3 space, Dutch auctions have also become prominent in token issuance. Issuance mechanisms based on the Dutch auction model offer greater fairness and help in determining the market fair value of assets. However, simple Dutch auctions may not fully meet all real-world needs. Therefore, innovative mechanisms like liquidity bootstrapping pools and progressive Dutch auctions are continually being developed. It’s important to analyze and adapt the use of this auction method according to the specific attributes of the assets involved.