Eurodollar
A time-deposit that is denominated in U.S. dollars and held in foreign banks
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What is a Eurodollar?
A Eurodollar refers to funds that are denominated in U.S. dollars and held in foreign banks, or overseas branches of American banks. These funds can in the form of cash deposits or term deposits.
These deposits were originally held in Europe, hence the name “Eurodollar” (i.e., U.S. dollars held in Europe). Eventually, several non-European countries were included as destinations for the U.S. dollar deposits, including the Bahamas and Cayman Islands.
As these funds are held outside of the United States, they fall outside of controls and regulations of the United States.
A Eurodollar is not to be confused with the Euro currency, nor with the exchange rate between Euros and the U.S. dollar, also called confusingly euro/dollar.
Key Highlights
- Eurodollars are U.S. dollars that are held in foreign banks and offshore branches of U.S. banks outside the United States.
- Other major currencies have also developed their own eurocurrency markets, helping to facilitate the borrowing and saving of currencies offshore.
- While the Eurodollar does create efficiencies in borrowing and savings rates, it also comes with its disadvantages.
History of the Eurodollar
The origins of the Eurodollar can be traced back to the post-World War II era. After the Allies were victorious, the Marshall Plan was enacted by the United States to help rebuild Europe. As such, there was a huge influx of U.S. dollars into Europe.
European companies and individuals who received those U.S. dollars didn’t want to deposit those funds back on U.S. soil (called onshore) and preferred to keep U.S. dollar deposits outside the U.S. (called offshore). Hence, they deposited the money into European banks, and thus, the Eurodollar market was born. It was this dramatic acceleration of foreign capital that paved the way for financial innovation in the form of the Eurodollar market.
Other foreign currencies also soon followed suit, creating offshore markets for other major currencies, such as the Japanese Yen, Swiss Franc, and the British Pound, outside of their domestic countries. The term “eurocurrency” encompasses the entire money market for a currency that is held in foreign countries and not in domestic markets. This market accelerated in importance as more countries introduced exchange controls after World War II. The controls made foreign deposits more attractive since they could be used as credit instruments by non-residents.
In the earlier days, the biggest players in the Eurodollar market were European and Asian companies, which preferred Eurodollars as a way to finance their imports from the U.S.
The U.S. dollar’s position became stronger partly due to an increase in profitable transactions of borrowing and depositing in the Eurodollar market. To be sure, the global financial system has seen a decline in liquidity problems correlated with the simultaneous increase in the growth of the Eurodollar and other eurocurrencies.
The Eurocurrency Market
Some attributes of the eurocurrency market are as follows:
1. Free of domestic regulations
As eurocurrency deposits sit offshore, banks that accept eurocurrency deposits often have fewer regulatory reserve requirements than their peers who accept the same deposits onshore. It may also be a way of working around currency restrictions or even banking regulations. These banks located offshore might also not be bound by limits on interest rates that might be imposed on banks located onshore.
2. Better rates
Eurocurrency market deposits may also earn higher rates. For example, since Eurodollar deposits sit outside the United States, they fall outside of depositor protection that might be offered by U.S. deposit guarantees, such as the FDIC. There may also be tax savings for deposits in the eurocurrency market.
Hence, in theory, depositors should expect higher rates for Eurodollar deposits in order to compensate them for the additional risk.
Borrowers may also receive cheaper borrowing costs through administrative or other financing cost savings. For example, a well-known Japanese company who needs financing in Euros might get a cheaper loan rate borrowing in their home eurocurrency market of Japan, where they have strong banking relationships, rather than try to find that loan in France.
3. Eurodollar futures contracts
The Eurodollar and greater eurocurrency markets have improved global liquidity for foreign currency deposits and loans. Furthermore, it has also created one of the largest markets for short-term funds via the Eurodollar futures market for financial institutions.
These futures allow financial institutions to effectively lock in deposit rates or hedge borrowing rates in a very liquid and standardized series of set maturities via a centralized exchange, such as the Chicago Mercantile Exchange or the NYMEX.
Uses of Eurocurrency
The eurocurrency market is commonly used by companies and financial institutions, such as hedge funds, in order to receive financing. It is often seen as an advantageous source of capital and a beneficial way to receive international funding because of its liquidity.
Banks that take Eurodollars and other currencies deploy those funds to lend back out as loans in the offshore markets or hedge in the eurocurrency futures market.
Individuals and businesses may also use the Eurodollar market or other eurocurrencies as a way to protect themselves against risks in foreign exchange and other capital controls, both in foreign and domestic markets.
The Eurodollar market is also a blessing for many countries with a balance of payments deficit, as borrowers are able to borrow funds offshore and reduce the potential foreign exchange reserve drain.
Eurobanks
A Eurobank is a financial institution that allows the deposits and loans of foreign currency. In other words, a Eurobank is a bank that accepts the use of eurocurrency as a financial instrument. A Eurobank can be located anywhere in the world – it does not need to be located in Europe only. For example, a bank located in Canada that holds South Korean won is considered to be a Eurobank.
Eurobanks enjoy restrictions and regulations that are more relaxed in comparison to typical banks, which allows them to reduce their operating costs. They might also not be able to offer the same deposit insurance that a deposit might get if they place their funds onshore. Hence, they might need to offer foreign currency deposits at higher interest rates to the depositor.
Eurobanks may also be able to lend out foreign currency loans at higher interest rates to borrowers. They can do so because the eurocurrency market does not have restrictions for interest rate ceilings, and borrowers might get a better rate than trying to secure the financing overseas, where they might not be as well-known or might not be able to offer as much security.
Eurobanks often make transactions with foreign currency in large amounts, as $1 million is often considered to be one unit. This is because the clients are usually businesses or large corporations that use Eurocurrencies to reduce financial risks.
Offshore Banking Unit (OBU)
Many Eurobanks operate as an offshore banking unit, or OBU for short. These entities are shell branches of a foreign bank located in a foreign international financial center, such as London, Hong Kong, Singapore, Dubai, the Bahamas, and the Cayman Islands.
These banks make eurocurrency loans, most commonly in Eurodollar markets and they accept dollar deposits in foreign currencies from foreign banks and other OBUs. However, as local banking regulatory authorities do not regulate OBUs, they are not allowed to accept deposits in the domestic currency or make loans to onshore customers.
Disadvantages of the Eurodollar
The Eurodollar (and the entire eurocurrency market) may seem too good to be true with all the benefits it brings. However, there are also disadvantages:
1. Weakened financial control
Naturally, due to the fact that it is unregulated by the U.S., the Eurodollar market can be seen as a way to circumvent financial regulation and control. A large excess of domestic currency being held offshore could also present a headache to the U.S. Federal Reserve when it comes to enacting effective monetary policy.
2. Risk of excess credit
Apart from the extra risk that savers take in placing their U.S. dollar deposits in foreign institutions by foregoing FDIC deposit insurance, Eurodollars are also being lent out to borrowers outside the United States.
This might increase the economic risk for excess credit as the loans might not be as well secured as if the loan was extended by domestic banks.
3. Exchange rate destabilization
Given the amount of U.S. dollars that are being held outside of the U.S., the Eurodollar system presents a real risk of pressure on foreign exchange rates. This also holds true for many other eurocurrency markets, especially those domestic currencies with foreign exchange controls in place.
Additional Resources
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