Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / Why Government Bond Auctions Are Rigged Against Retail Investors
Transcript
- Lucas: Every three months, the U.S. Treasury borrows about three-quarters of a trillion dollars by selling bonds to the highest bidder — but 'highest bidder' means something very specific, and it's not what most people think. Luna: Yeah, because when you or I buy a Treasury bond on our brokerage app, we're not really 'bidding' in the same sense as the big banks. Lucas: Exactly. The Treasury runs these auctions — for bills, notes, and bonds — and they use what's called a single-price auction format. Every winning bidder pays the same price, which is the lowest price that clears the auction. That sounds fair in theory, but the way the auction is structured, the biggest players have a built-in advantage. Luna: So how does it actually work? Walk me through the mechanics. Lucas: Okay. So the Treasury announces a certain amount it wants to borrow — say, $40 billion in 10-year notes. Then it accepts bids from anyone who wants to buy. You can submit a competitive bid, where you specify the yield you're willing to accept, or a non-competitive bid, where you agree to accept whatever the auction clears at. Non-competitive bids are capped at $10 million per bidder, and they're filled first. Luna: Right, so that's the retail-friendly window. Small investors can submit a non-competitive bid through TreasuryDirect and know they'll get filled. Lucas: Yes, but here's the catch — non-competitive bidders only get allocated about 10 to 15 percent of the total issuance on average. The remaining 85 to 90 percent goes to competitive bidders. And within that group, there are 24 primary dealers — the giant banks like JPMorgan, Goldman Sachs, and Citigroup — who are required to bid at every auction. They get the lion's share. Luna: And they also get to see the order book, basically. They have a feel for what other bids are coming in. Lucas: That's the key. The primary dealers have direct access to the auction system and they can submit bids up until the moment the auction closes. They also trade in the when-issued market — that's the forward market for the bond before the auction — so they have a very good sense of where the yield will land. Retail investors don't have that same visibility. If you're buying through a brokerage, the brokerage typically submits a competitive bid on your behalf, often at a yield that's a bit worse than what the big players get. Luna: So the retail investor ends up with a slightly lower price — meaning a slightly higher yield for the Treasury, but a lower return for the investor. Lucas: Precisely. And it's not a huge difference — maybe a couple of basis points on average — but over hundreds of billions of dollars of issuance, that adds up. There's a 2022 study by researchers at the Federal Reserve Bank of New York that found retail investors who bid non-competitively actually get better terms than those who go through a broker. But most people don't know about TreasuryDirect, and the interface is clunky, so they don't use it. Luna: And if today's episode about how the auction system works made something click for you, honestly, if it was worth a coffee to you, that link is buy me a coffee dot com slash fexingo. It's the smallest possible ask, but listener support is what keeps this show ad-free. Lucas: Yeah, we don't run sponsor spots, we don't have a Patreon with tiers — it's just a coffee if you feel it. And it genuinely helps. So, back to the auction mechanics — the single-price format means that all winning bidders pay the same price, but the way the auction allocates supply gives primary dealers a natural edge. They can bid aggressively because they have the balance sheet and the information. Luna: So what would a reform look like? Something that levels the playing field for regular investors? Lucas: The Treasury Borrowing Advisory Committee — that's the group that advises the Treasury on debt management — actually floated a proposal a few years ago. The idea was to allow non-competitive bidders to submit bids up to a higher cap, maybe $100 million, and to give them a guaranteed allocation of at least 20 percent of each auction. That would ensure that smaller buyers get a bigger slice. Luna: Did anything come of that? Lucas: Not yet. The Treasury has been cautious, partly because the primary dealer system is deeply embedded in the market infrastructure. Dealers provide liquidity, they make markets in Treasury securities, and they absorb a lot of the risk. If you shift too much allocation away from them, you could disrupt the secondary market. So it's a balancing act. Luna: But isn't there also an issue with how the auction itself is timed? I remember reading that the Treasury closes bidding at 1 PM Eastern, but the when-issued market continues trading. So dealers can effectively hedge their positions before the auction results are announced. Lucas: That's a really important point. The auction closes at 1 PM, but the results aren't announced until around 1:30. During that half-hour gap, dealers can trade the when-issued security based on their knowledge of their own bids and their sense of the market. That's a window of information asymmetry that retail investors don't have. Luna: So it's not just that they have better information before the auction — they also have a post-auction advantage. Lucas: Right. And there's a related issue called 'squeezing' — where a dealer or a group of dealers corners the market in a particular bond issue, forcing short-sellers to cover at high prices. The Treasury has rules against this, but it's hard to detect and enforce. Luna: You mentioned that non-competitive bidders get better terms on average. Is that because they're basically taking the auction-clearing yield without trying to game it? Lucas: Exactly. Non-competitive bidders always get the average yield of the accepted competitive bids. So if you submit a non-competitive bid through TreasuryDirect, you're essentially getting the same yield as the primary dealers who bid at the margin. It's a simpler, more transparent process. The problem is that TreasuryDirect's user interface is notoriously bad. It looks like it was designed in the late 1990s, and the login process is clunky. So most retail investors don't bother. Luna: Well, that's a solvable problem. The Treasury could modernize the platform and then run a public awareness campaign. But I guess there's no political will for that. Lucas: Probably not, because the current system works well enough for the Treasury's main goal — which is to borrow at the lowest cost possible. The primary dealer system keeps the auction process efficient, with tight bid-ask spreads and high participation. From a pure cost of borrowing perspective, the Treasury doesn't have a strong incentive to change it. Luna: But from an equity perspective, it's a bit of a closed shop. If you're an individual investor with a few thousand dollars to put into Treasuries, you're effectively getting a worse deal than the big banks. Lucas: Yeah, and the difference compounds over time. Let's say you're buying $10,000 worth of 10-year notes every year. If you're losing 2 basis points per year because of the brokerage spread, that's $2 per year, which is trivial. But if you're a larger retail investor with $500,000 in Treasuries, that's $100 a year, and over 10 years that's $1,000 — not nothing. Luna: And then there's the issue of auction allocation when there's a tail — when the auction stops at a yield that's higher than the when-issued market. That can signal weak demand, and it often happens when the market is volatile. Lucas: Right. A tail occurs when the auction yield is higher than the when-issued yield at the time of the auction. That usually means the Treasury had to offer a higher yield to attract enough bids. In those situations, primary dealers often end up with a larger share of the auction because they step in as buyers of last resort. That's actually part of their obligation — they're required to bid in every auction, even when demand is weak. Luna: So they're like the liquidity providers of last resort for the government's own debt. Lucas: Exactly. And the Treasury compensates them for that role by giving them exclusive access to certain trading platforms and by allowing them to trade with the Federal Reserve's System Open Market Account. It's a symbiotic relationship. But it does mean that the retail investor is always a step behind. Luna: Okay, so if I'm a retail investor listening to this and I want to buy Treasuries on a more level playing field, what should I do? Lucas: First, open a TreasuryDirect account. It's free. Then, when you want to buy a bond, use the non-competitive bidding option. You'll get the same yield as the institutional bidders. The only downside is that you have to wait for the auction date — you can't buy whenever you want. But for long-term investors, that's usually not a problem. Luna: And for those who want more flexibility, are there ETFs that can replicate Treasury exposure without the auction friction? Lucas: Sure, but you're paying an expense ratio — typically 0.03 to 0.10 percent for Treasury ETFs. That's a few basis points, which is roughly the same as the spread you'd pay through a broker. So it's a trade-off. But for most people, an ETF is simpler and gives you daily liquidity. Luna: So the auction system isn't rigged in a malicious sense, but it is structurally tilted. And the fix is pretty straightforward: better access for non-competitive bidders and a modernized TreasuryDirect. Lucas: Yeah, it's one of those areas where a relatively small policy change could make a meaningful difference for individual investors. The Treasury could, for example, increase the non-competitive bid limit from $10 million to $50 million, or guarantee a minimum allocation of 25 percent to non-competitive bidders. That would give retail investors a better shot without disrupting the primary dealer system. Luna: And it would also signal that the Treasury is thinking about fairness, not just efficiency. Lucas: Right. The Treasury's dual mandate is to borrow at the lowest cost and to maintain a liquid secondary market. But there's a third goal that's often overlooked: ensuring broad and fair access to the government's own securities. After all, it's our debt — we should all be able to buy it on fair terms. Luna: Agreed. Alright, next episode we're going to look at something completely different: how the government's own accounting rules make its finances look worse than they really are. See you then.