This is the most important market in the world. It is the single, largest source of global funding. There is nothing even close to what the Eurodollar market produces. Since it is outside the control of any single entity, it is impossible to know exactly how large it is. However, it is estimated that more than 90% of global trade is financed through the Eurodollar system.
In other words, it is the world's primary capital market. For this reason, the banks require a steady flow of deposits. Failure to achieve that, liquidity issues will arise, creating other problems.
How Big Is Eurodollar Market?
Deposits in eurodollars amount to hundreds of billions of dollars per day. It is not uncommon for banks to accept deposits for $500 million or more.
Short-term lending in the Eurodollar market also reaches some insane proportions. We see, through tri-lateral data assembled from primary dealers along with the custodian (Bank of New York Mellon), that it can reach $5 trillion daily. Since much of this market operates outside the view of these entities, we can presume it is significantly higher.
When Did The Eurodollar System Start?
Like size, there is really no firm point in time where we can say the Eurodollar system began. We know that eurodollars came primarily into being after World War 2. During that time, because of the Marshall Plan, billions of USD banknotes were sent over the Europe. These ended up as time deposits in European banks.
As the bankers realized they were sitting on a plethora of cash, the idea to start utilizing them came into being. Where this kicked off is unknown but some theorize the Soviet Union and China were looking to get their dollars out of the reach of the US Government. The Eurodollar system provided the perfect solution.
Over the ensuing decades, the system grew in size. Banks started to engage in loans, collateralization, swaps, futures, remittance, and cross-border payments. Much of this was based upon relationships between individuals at the different banks. It also mostly occurred off balance sheet.
The futures are traded on the Chicago Mercantile Exchange (CME). These are derivatives of the interest rates paid on the eurodollar deposits. It is a cash settled contract that has price moves in response to the LIBOR interest rate.
Midland Bank
One of the central players in the early stages of the Eurodollar System was Midland Bank. In 1957, it was engaging in a lot of activity on the exchange, separate from core operations. The Bank of England realized that Midland was borrowing USD and swapping it for sterling. This allowed it to invest in opportunities within the U.K., mostly Treasuries.
At this time, there was a tight monetary policy. Many feel this caused the banks to look elsewhere for liquidity. Since there were policies against credit in sterling, the financial institutions found away around it. This was the Eurodollar System.
All of this was against the backdrop of the Bretton Woods agreement which sought to restrict capital flows around the world. Policy makers believed it was speculation that caused the collapse of many currencies during the 1930s. They concluded that restricting capital flows was the solution.
Finance is, by nature, designed to provide liquidity. The financial industry started Eurodollar System simply to meet demand. Global trade requires money, something that was restricted by Bretton Woods. This was the true reason why the Eurodollar System came into being.
A case could be made that regulation and policy was the impetus that caused the financial institutions to take matters into their own hands.
The Great Financial Crisis
History is overlooking the Eurodollar System's role in the Great Financial Crisis. Many feel it was stared by the issues with the United States subprime mortgage market. The problems there aside, the money involved is simply too small to wipe out the global economy. Instead, it had to be something bigger.
The Eurodollar System was at the center of this. What kicked off the GFC was a bank run. This one differs from the traditional model in that customers were not heading to branches to be made whole on their deposits. In this instance, it was the banks themselves that were scrambling to secure their collateral.
At the heart of this were mortgage backed securities (MBS). These were rated the same as U.S. Treasuries. This led the financial institutions to use them in the same manner, believing the liquidity would be there when needed. When that dried up and certain banks had trouble valuing their funds (assets), things started to unravel.
Bear Stearns was ultimately done in by a collateral call by the Tri-Party Repo custodian, JP Morgan. It was for $5 billion, an amount the investment bank did not have.
As other institutions started to question the validity of the collateral they had loans against, markets started to dry up. This put enormous pressure on the entire system. Ultimately, the other side of the MBS, the insurance company was under stress. The solvency of AIG, the one backing much of this, was at risk.
This is why the US Government had to step in and backstop AIG. If not, the entire funding market around the world would be frozen.
Sovereign Debt
The Great Financial Crisis took out the private sectors contribution to the Eurodollar System. In the Repo markets, lenders were now engaged in secure lending. The best form of collateral ended up being sovereign debt. Nations around the world were trying to make up for deficit spending during the GFC by issuing debt in large quantities.
This held serve for a while although the system was slowed a bit. When the balance sheet capacity of the banks is hindered, the Eurodollar System suffers. It was about to experience another shock.
Within 5 years of the GFC, many of the central banks decided to push forth negative interest rates. This was in keeping with a philosophy that said NIRP will force cash out of the savings accounts and, thus, into the economy. This is how growth rates could be pushed higher in the face of stagnation.
The problem is that, when the central banks did this, it destroyed the different bond markets. With much of the sovereign debt off the table, the Eurodollar System really started to struggle.
What resulted was U.S. Treasuries. Since the Federal Reserve did not push through the zero interest rate policy and kept out of negative territory, they remained the high quality and pristine collateral. As long as the Treasuries were on-the-run (OTR), they will garner the best interest rates and collateralization rate.
Here is where the system experienced deflationary money since the end of the GFC. By removing the MBS and most of the sovereign debt from the system, bank balance sheets are constrained.
Central Bank Raising Interest Rates
In 2022, many central banks around the world started to raise interest rates. The Federal Reserve pushed them up at a pace never seen before. This caused more issues in the Eurodollar System.
While it was established outside the reach of any central bank or government, the system is dependent upon collateral. Since Treasuries were the main asset used, the value is vital to the system.
With the Fed raising rates, the price of the bonds collapsed. This caused two issues. The first is the value available for collateral, i.e. lending, is reduced. When bonds are trading at 40% or 50% of their par value, that is a major hit especially when spread over the $125 trillion bond market.
The second issue was with liquidity. With the value of bonds dropping, especially at the long end of the yield curve, demand is crushed. This is fatal for collateral since the market dries up completely. Collateral, especially for short term loans requires liquidity as soon as markets open. Lenders are not will to take the risk of being caught having to hold the asset.
Both of these added to the balance sheet constraint the system operated under since the Great Financial Crisis. This has the effect of slow economic growth in the economy with GDP taking a hit.
Ledger Based Money
The Eurodollar System no longer use any eurodollars. Like most monetary systems, we are dealing with ledger based money. Since the introduction of double entry accounting, the money changed completely.
Settlement is not done using banknotes. A major component of the monetary system is accounting. Ledger entries are how money is created through fractional reserve banking and tracked. The Eurodollar System operates under the same premise.
The "eurodollars" used are mostly digital. The US dollar is the unit of account that makes up most of the system. This is why it is also known as the "Offshore Dollar System". These have nothing to do with the Federal Reserve, being created by financial institutions.
All transactions are recorded on the different ledgers. This is a closed system run by banks and other financial entities. They engage in the creation of new money based upon balance sheet assets.
Collateral is the currency used in this market. Assets, mostly denominated in US dollars make up a majority of the total.
Cryptocurrency And Digital Assets
The Eurodollar System is ledger based money operating in the digital world. It predated Bitcoin by 60 years. Cryptocurrency is likely to be a part of the future system.
Blockchain utilizes distributed ledger technology (DLT). It alters the ownership of the ledger, taking it out of the hands of centralized corporations. The decentralization is what instills the trust in a system that is considered trust-less.
In the Eurodollar System, trust is based upon relationships and the liquidity of the assets put up as collateral. With digital assets, the idea is to have the code and the decentralization of the blockchain as the basis of the confidence. This is how counterparty risk is reduced by removing a centralized entity from the equation.
This is important for the potential of collateral. Since the implosion of mortgage backed securities, the private sector has not provided anything to offset the deficit in high quality collateral. This is compounded by the degradation of the much of sovereign debt.
Cryptocurrency offers the opportunity to design collateral that is utilized globally. By recording it on blockchain, it is both immutable and transparent. This is how the evolution of the decentralized finance (DeFi) can make a massive impact. It is a problem that exists which can be solved through innovation.
The development of the Eurodollar System could be a road map for cryptocurrency to follow. Instead of private, reserve-less bank money, digital assets are the same, minus the banks.