The Economies of the Dutch Auction Systems
July 20th, 2009 Manasseh Egedegbe || manasseh.egedegbe@stockmarketnigeria.com
In January 2009, the former CBN Governor switched the foreign exchange trading to the Retail Dutch Auction System (RDAS) from the old Wholesale Dutch Auction System (WDAS). Exactly six months after that the CBN has gone back to the WDAS; although it was the ex-Governor that set the ball rolling.
What is the difference between the RDAS and the WDAS and how does this difference affect the general economy and in extension the stock market, using the Nigerian Stock Exchange as a proxy? A general explanation will be given in this article and as usual, my view is in favor of the free market.
The Dutch Auction is a type of auction system in which goods (or services) are sold by an auctioneer who starts from the highest possible price. The auctioneer reduces the price gradually until a buyer is willing to purchase the good. It is the opposite of the traditional auction system in which bidding starts from the lowest possible price until no one else is willing to bid above the last highest bid. RDAS and WDAS use the Dutch Auction system.
In RDAS, the banks come to the foreign exchange market with demands from the retail users of the foreign currencies; they usually come with documentations detailing the use of the currencies and there is a restriction on how much can be purchased at a time and how many times in a week (and how long) the market would open. This system was introduced by the CBN in order to protect the foreign reserves from the high demand for foreign currencies as the flight from the Naira to other currencies skyrocketed. This was due to the fact that investors and businessmen were not sure of the direction the Nigerian economy faced, as inflation went into the high teens. Banks came up with restrictions on foreign exchange and successfully starved many end users who needed the foreign currency for legal (and illegal) transactions. This played out into the parallel market as it became the only source of foreign currency for many end users; the gap between the demand and supply led to a large disparity between the official rates (the rates at which the banks bid for the currencies from the CBN) and the parallel rates (also called the black market, which became the only source for many end users).
A black market is usually created whenever regulations restrict market flow. This leads to a deadweight loss as market participants look for ways to fulfill their demands and therefore end up paying more than the regulated price and even the price that would have been, given that there was no regulation. This disparity between official and parallel market became so large that many market players saw an opportunity to make a quick profit by buying at official rates and selling at black market rates. The banks saw this and created more restrictions which ended up with a vicious cycle that worsened the deadweight loss.
In WDAS, the banks go into the foreign exchange market without restrictions (except perhaps the restriction on the percentage of shareholders’ fund that they can take to the market, which is currently 5%) and buy as much as they can afford to resell to the end users. Because of the reduced restriction, there is lot of foreign currency around to fund the demands that are mostly legitimate, but hitherto restricted, and the gap between the parallel rate and official rate collapses as is currently playing out in Nigeria. The arbitrage players see a reduced profit margin and they move on to other businesses and everything goes back to ‘normal’.
The RDAS created volatility in the exchange rates as black market players and illegal transactions made the demand for foreign currency uneven. Foreign investors who were looking at investing in the Nigerian economy saw this volatility and they got scared and decided to stay away. Large local investors who saw this decided to keep their monies in money markets instead of dipping into equities. This led to a reduction in demand for Nigerian equities by foreign investors and reduced investments in businesses. There was also a change in direction of money; black market players who would have invested in equities decided to bid for foreign currencies through the banks by ‘settling’ bank officials and reselling to the black market at higher rates. Legitimate businesses that needed the foreign exchange but could not cross the tight hurdles created by the banks had to source for foreign currencies from the black market but there is a constraint on how much they could pass on the their customers, and coupled with the fact that they also have to generate their own electricity, profit margins were wiped out. Many of the companies listed on the stock exchange that did not have any problems with sourcing for foreign currencies were however affected by the depreciation in Naira and those that depend on businesses that needed foreign currencies for their businesses also faced high cost of inventories, which also saw a slide in profit margins; this led to lower earnings and reduced cash flow, which ended up with lower valuations of stocks on the NSE.
The combination of all these factors with a rising cost of capital created an economic shock, stagflation, which the country is currently battling with and time will tell how the new CBN Governor, Sanusi Lamido Sanusi (SLS), will manage the monetary policy to get Nigeria out of this quagmire.
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