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Eurodollar Market

Eurodollar Market

Another good source of liquidity for banks besides repos is the eurodollar market. The eurodollar market is a market for dollar deposits outside the US. Banks outside the US accept dollar deposits since they are not subject to any regulations on deposit rates or reserve requirements and hence can offer better rates. These banks that participate in the eurodollar market are called eurodollar banks.

Due to increasing regulations in the US there was a growing demand for placing dollar deposits outside the US. At the same time the dollar was replacing the pound as the international currency for trading. The postwar monetary system moved to dollars from the pound and most countries kept their reserves in dollars.

Because of the regulations in the US many countries wanted to hold dollars however not in the US. This opportunity was a blessing for London banks who started borrowing and lending in dollars. The London banking sector is dollars came to be known as the Eurodollar market.

Lets take an example of how this works to understand it better. Assume that IBM US wants to make a $10 million Eurodollar deposit with JP Morgan London. IBM will issue a $10 million check drawn on its US bank Wells Fargo. When the cheque clears the effect of the bank’s balance sheets will be as follows

Wells Fargo Bank US

Assets

L+E

Checking Depo – IBM

-10

Checking Depo – JP Morgan

+10

created a borrowing from JPM

 

JP Morgan London

Assets

Depo at Wells Fargo US

+10

Loan to WF

L+E

Time Depo – IBM

+10

Time deposit IBM

These are all book entries. No physical dollars have left the US. The ownership of $10 million deposits of IBM at Wells Fargo have been passed from IBM to JP Morgan London. IBM has converted this checking deposit to a time deposit in eurodollars at JPM London. $

JP Morgan does not earn any interest on the deposit with Wells Fargo US and needs to pay IBM on its deposit. Therefore in order for the London Bank to make money it needs to lend the dollars. Assume it lends the dollars to Apple or places these dollars in the interbank market overnight or term deposits.

Assuming JP Morgan makes a loan to Apple the balance sheet would look like

JP Morgan London

Assets

Depo at Wells Fargo US

-10

Loan Apple

+10

L+E

Time Depo – IBM

+10

Since these are Eurodollar funds JP Morgan needs to make the loan by writing a cheque on its deposit at WF US. Eurodollar banks in London are not allowed to offer checking deposits. If the BOE allowed that it would increase

the money supply in UK without the actual dollars flowing in.

Assuming Apple banks with Citibank New York where it deposits the cheque, the balance sheet of WF and Citi would be affected as below

Wells Fargo Bank US

Assets

Deposit at Fed

-10

L+E

Checking Depo – JP Morgan

-10

Citibank’s balance sheet would be

Citibank US

Assets

Deposit at Fed

+10

L+E

Checking Deposit – Apple

+10

So we see that the London banks act as intermediaries for eurodollars. All dollar transfers are made between the US banks electronically and not through cheques, no transfers are made outside the US and therefore eurodollar banks depend on US banks to effect the payments.

So we can summarise our understanding of the eurodollar market as a market that basically emerged due to the restrictions and regulations on deposit rates, lending to foreigners, deposit insurance premiums etc. Due to the disadvantages faced by the US banks many regulations were eventually dropped. However the eurodollar market continues to flourish to date as it provides US banks an opportunity to move some business offshore beyond the regulators reach.

Next we will study another very important source of funds for banks – The Federal Funds Market.

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