IT and the Pricing of New Securities: An Experimental Comparison of a Direct Auction System with Traditional Underwriting

Experimental economics techniques are used in this paper to examine the benefits and potential adoption of Internet-based electronic auctions for the initial public offerings (IPO) market. The IPO market is dominated by investment banks, which organize the promotion, pricing, and allocation of new securities. The high transaction costs and inefficiency evident in the IPO market make it an apparent anomaly among modern financial markets. Issuers pay high commissions, issues tend to be underpriced, and individual investors have virtually no direct access to the market. Emerging Internet-based markets organized as electronic auctions offer an alternative to traditional practices, and can potentially reduce costs and improve market quality. The auction and traditional intermediated market structures were replicated in a laboratory environment. Subjects playing the role of investors and investment bankers participated in simulated IPO markets involving various levels of risk and buying pressures similar to those expected in actual IPOs. The offer price and the revenue to the market participants observed in the auction were compared to those collected in the intermediated market. Results show that auction prices were greater than traditional intermediated market prices when the value of the securities offered was more uncertain. As uncertainty decreased, auction prices became comparable to intermediated market prices. Issuers received larger proceeds when going public through the auction. Investors’ overall profits were positive in both market structures, although they were significantly higher in the intermediated market.