Collusion or Unreasonable Rules: Evidence from Chinese IPO Underpricing

The high rate of IPO underpricing in China has attracted extensive academic attention. An average rate of 238% was reached in this market between August 24, 2020 and November 20, 2021, which is much higher than that of more mature markets. The rate continued to rise after the end of 2020. This high IPO underpricing rate may be partly explained by the winner's curse theory, and factors such as investor sentiment and the issuance system may be involved, but the reasons for this rising trend of the IPO underpricing rate remain largely unknown.
Some media have argued that the increasing underpricing rate is related to collusion. Institutional investors may conspire to report a low price and thus to avoid elimination and obtain a higher rate of return, and so the prices quoted by these investors will continue to fall. However, collusion is unlikely to occur when there are numerous institutional investors.
I combined the historic movements of stock prices with the relevant policies and identified high-price elimination rules in the system introduced by the China Securities Regulatory Commission (CSRC) in August 2020. After offline investors quote, the underwriter is required to eliminate at least 10% of the highest quotations, and these investors do not receive shares. Thus, unlike in American or Dutch auctions, the bidding of offline investors in China's IPO pricing system does not result in the highest bidders obtaining stocks, as bids that are too high or too low will be eliminated. Thus, offline investors have an incentive to increase their winning rate by quoting intermediate prices under the new system because of the small number of new shares in the market and because winning the shares always yields a relatively high return.
I therefore proposed an interpretation to explain how and why China's market had such a high underpricing rate. I believe that the IPO pricing rules are flawed, and I establish that the quotation rules aimed at eliminating high prices encourage under- quotation. The gradual decline in market quotations is an inevitable result of the new policy, as it affected the incentives of offline investors, who consequently quote intermediate prices rather than identifying the true value of a firm. Equilibrium is reached when all quotations are the same, and as offline investors can obtain higher returns from lower quotations, the result tends to be a uniform quotation at a price that tends toward zero. Thus, I predict that the issuing company can increase its valuation before going public to reduce the underpricing rate and can obtain more financing as compensation for IPO underpricing.
To better understand China's financial market, I also conducted a case study of Dook Media to demonstrate the severity of the pricing inefficiency problem. I analyzed this problem using the data obtained, and the empirical results are consistent with my theory.