How Eurodollars really work

Article by GlobalMacroForex

As we discussed in my previous article on how fractional reserve banking works, commercial banks can expand the money supply up to 10 times what the Federal Reserve creates by loaning demand deposits.  Each bank holds 1/10 their total demand deposit loans as reserves at the Fed.  In how the interbank clearing system works, we showed how when one bank loans to another overnight, it’s done through the Fedwire and priced off the Fed Funds rate.  This just means the Fed transfers ownership of the reserves from one bank to another.  The Fed doesn’t actually hand each other anything; the Fed just changes ownership of the reserves on its books.

Now let’s review the Eurodollar market.  A Eurodollar is a claim to a US Dollar at a bank physically located outside the United States.  For example, it’s like a dollar liability against a “New York” bank except this bank is in England.  The term “euro” before a currency means money lent offshore from the country the currency is from.  For example, a Euroyen would be a Yen loan outside Japan, a Euroeuro would be a Euro loan outside Europe.  It has nothing to do with the Euro — the official currency of the ECB/Europe.  This name Eurodollar comes from the fact most USD loans outside America were in Europe.

There are a few differences between Eurodollars and US-located dollars.  In America, banks are part of the Federal Reserve system and legally have to pay FDIC insurance premiums as well as keep 10% of its loans on reserve at the Fed.  Eurodollars are not subject to Fed reserve requirements or FDIC insurance.  So they are riskier, which should command a higher interest rate on deposits. 

However, the biggest difference between Eurodollars and American held dollars is fractional reserve banking on top of fractional reserve banking.  Each American fractional reserve dollar serves as the base reserve to the Eurodollar system.  To understand how this works, let’s first revisit how American banks multiply money off of their base reserves held with the Fed.

Under this system, the Fed has reserves, and banks multiply the money supply by lending off those base reserves.  When banks loan to each other, the Fed transfers ownership of the reserves.   Each of those domestic dollars then serves as the base money to loan on the Eurodollar market.  In a sense, domestic American banks act similar to the Fed, transferring ownership of access to real American currency between foreign banks. 

Let’s walk through the process using the example given by Milton Friedman in his 1971 paper on the Eurodollar market.  Imagine an Arab Shiek sells oil to a New York company.  The Shiek receives ownership claims on a deposit held with a New York bank.  The Shiek now wants to transfer this money to a London based bank.

Throughout my visual example, an arrow represents a loan to a deposit.  So in this case, the London Bank takes control of the deposit previously controlled by the Arab Sheik, and the Sheik now has a deposit with the London Bank.  So the deposits of the New York bank don’t change.  Just by transferring the money to the London branch, it has “created” eurodollars.

The London bank now lends to a British exporter who wants to match the USD he will receive from his exports with dollar liabilities.  The London bank doesn’t loan the full amount though; they keep some (unregulated) amount of their choosing for liquidity needs.  Just for simplicity sake, let’s say it’s 10%, even though it’s not required like US-based Federal Reserve banks.  When the London bank makes the loan, it transfers ownership of $9 of the deposits at the New York bank.

So now the New York bank is acting similar to the Federal Reserve in America.  Since these offshore entities don’t have similar access to USD that the onshore American entities would, they are trading assets at a bank who does.  In our picture, green arrows represent the original liabilities to American banks.  This hasn’t changed from $10.  Only the ownership of those deposits has changed, so Eurodollars don’t change Federal Reserve measured money aggregates like M1 or M2.

The blue arrows represent Eurodollar claims, and as you can see this supply has nearly doubled.  Next, the British exporter places his New York bank assets with a German bank.  Since it’s not a loan but a deposit, the exporter deposits the full amount.

This German bank now makes a loan to a German company, again keeping 10% behind for liquidity needs and transferring ownership of deposits at the New York American bank.

The implications of this are amazing.   To quote Milton Friedman’s 1971 paper,

“This example perhaps makes clear why banks in the Euro-dollar market keep insisting that they do not “create” dollars but only transfer them, and why they sincerely believe that all Euro-dollars come from the US.  To each banker separately in the chain described, his additional Euro-dollar deposit came in the form a check on the New York Bank!  How are the bankers to know that the [$10] of checks on the [New York bank] all constitute repeated claims on the same initial [$10] of deposits?  Appearances can be deceiving”

So Eurodollars are like fractional reserve banking on steroids:

1)  The explosion in eurodollar bank liabilities don’t show up in Fed money statistics.

2)  Eurodollar bankers are also unaware of the intense leverage on the system for the same American dollars

3)  Funds are not subject to reserve requirements

4)  There is no FDIC insurance

5)  One doesn’t need a trade deficit, illegal black market transfers, or tax evasion to get Eurodollars

6)  There’s an inability to translate all these claims back to America

7)   When Eurodollars are actually recycled back to America, it reduces the reserve requirements of US Banks, when in actuality, it’s increasing the leverage on those same claims for Federal Reserve notes

To understand point #7, when a Eurobank lends to a second US bank those same US deposits, it turns it into a foreign bank CD when in actuality it’s really a demand deposit claim.

This is lowering government measured reserve requirements on the second bank (but not the first) while increasing overall systematic risk.

So in essence, Eurodollars are not real US dollars because they can’t actually all be converted into Federal Reserve notes.  I agree they are liquid and convertible only in good times.  In bad times it’s non-FDIC insured, no-reserve requirement claims to claims to claims to Federal Reserve notes.  In my opinion, this is part of the reason that internationally traded goods denominated in USD (for example oil) will always inflate in price more than domestic American-only consumed goods, such as a haircut.  There are all these extra Eurodollars around that can never actually circulate back to American Federal Reserve banks.

Often one hears claims such as “half of the dollars are owned by foreigners and therefore one day they will dump dollars and it will hyperinflate.”  In my opinion, the Eurodollar combats hyperinflation (but increases steady/normal inflation) because there are more Eurodollars than Federal Reserve notes that can be delivered, so the very act of trying to dump Eurodollars creates intense deflationary demand for USD.  While it’s possible the USD could hyperinflate for other reasons (e.g., dumping Treasuries not Eurodollar demand deposits), ultimately the Eurodollar is similar to the offshore renminbi except America has an open capital account.

In the next article, I’ll analyze how LIBOR works and why it’s a bizarre gauge of the Eurodollar market.