How the Eurodollar system works (and why it matters)
Peaking under the hood of the massive offshore dollar market
The Eurodollar might be old news for some of my readers, but bear with me. I plan on writing several pieces that reference the offshore dollar market and I need an article to link to. If you’re already a Eurodollar aficionado, kudos. May the collateral be with you. If not, this piece should clear a few things up. I’m not a financial expert, but I think that I have a basic grasp of what’s going on here and can explain the system in a fairly simple way.
Let’s dive in.
What is a Eurodollar?
The “Euro” in Eurodollar doesn’t refer to the Europeans or their funky currency. “Eurodollar” refers to offshore dollars. I.e. dollars moving around internationally, outside of the American banking system. The Federal Reserve does not control the Eurodollar system, nor does any other American regulator.
The Eurodollar network is comprised of international banks and money lenders, with a few hubs like London, Tokyo and the Cayman islands playing a key role. Here’s an example of how a transaction might work in the Eurodollar system.
A manufacturing firm in Thailand wants to borrow dollars to build a new factory
A Thai bank wants to provide the loan, but they don’t have enough dollars. However, the bank does have some United States Treasury notes
The Thai bank pledges the notes with a money lender in Singapore
The Singapore money lender accepts the notes as collateral and issues the Thai bank dollars, which the bank then gives to the factory owner
This is a crucial point: at no point are physical dollars involved in this transaction. There’s no cash because the Eurodollar is a ledger system. Banks and money lenders update their ledgers and that’s how so-called dollars are transferred. The creation of “dollars” comes down to accounting gimmicks.
Here’s a question I had at one point: that’s all fine and fantastic, but how does ledger money translate into real goods and services? What happens when the factory owner wants to spend Eurodollars on something like concrete? Where does the rubber hit the road?
The Thai factory owner buys concrete from the local concrete repository, a business that probably banks at the same place as the factory owner. To transfer dollars from the factory owner to the concrete consortium, the bank only needs to rearrange its ledger. It debits some dollars from the factory owner and credits them to the concrete man’s account. Done and dusted, that’s it!
This entire system is based on updating ledger balances. What is the Eurodollar? It’s banks claiming to have dollars and if asked for proof they point to their ledger and say look: the dollars are right there!
Two things keep this ledger-based money system running.
Trust… The Eurodollar system is self-regulating. The financial institutions that participate need to trust each other. If a participant is deemed untrustworthy they might be asked to post more collateral, or denied access altogether. For example, Credit Suisse might be having some trouble participating, given its monetary issues.
Collateral… High quality collateral is to the Eurodollar system what gasoline is to an engine. It makes the whole thing work. To get a loan you need collateral. If an entity fails to repay the loan, the other party can liquidate the collateral and get their money back. US Treasuries are the gold standard in collateral, but other types of assets are also accepted. For example, Italian BTPs and German Bunds.
Why does the Eurodollar system exist?
The Eurodollar exists because people and institutions outside of the United States want to borrow dollars. The Eurodollar is like an informal continuation of the American banking system, except that you need collateral to get a loan and there are no physical dollars.
How does the Eurodollar system affect you and I?
When the Eurodollar system works well, the world benefits. As with the example of the factory in Thailand, the Eurodollar system funds economic growth. It gives international businesses the capital they need to expand their operations. If the financial institutions in the Eurodollar system are unwilling to lend, it can slow down growth.
Furthermore, the supply of Eurodollars is larger than M2 in the United States. That means that Fed policy is limited in its effectiveness. If the Eurodollar system is working well, there is dollar growth. If money lenders in the Eurodollar market are feeling skittish the dollar’s expansion may stop. All of this happens outside of the purview of whatever the hell our monetary overlords at the Fed and Treasury are trying to accomplish with their policies.
Finally, having a basic grasp of how the Eurodollar system functions is necessary to discern the impact (or non-impact) of QE, higher interest rates, bond prices, etc. Some things that happen in the market don’t make sense on their own, until you can see these outcomes from a broader money perspective.
Are there any problems with the Eurodollar system?
Collateral shortage is a constant problem in the Eurodollar system (exacerbated by rising interest rates which cause bond values to drop). As I mentioned, US Treasuries are the best collateral but not everyone has easy access to them. German Bunds could be another source of high quality collateral, but the German government doesn’t borrow enough so the available supply of Bunds is not so large.
Hugh Hendry has talked about Italian BTPs being used as collateral not because institutions trust the Italian government, but because Italy issues so much debt that its profligacy makes its bonds an abundant source of collateral.
Here is a quote from Hari Krishnan discussing that lack of collateral. Quote is taken from the ~10 minute mark.
There’s only about $20 trillion of Treasuries that can be recycled in the global economy to support the Eurodollar lending markets and the other global lending markets. So, at some level there’s actually a shortage of Treasuries. This is creating a very awkward situation, where there’s too much debt but too little collateral to support the rolling over of debt over time.
Final remarks
The Eurodollar system is massive. Jeff Snider has said that nobody knows exactly how large it is, but the number is certainly measured in the tens if not hundreds of trillions. Although the system is quite complex, there are just a few key points that I use to understand it.
The system requires collateral, which means that there is a constant bid for US Treasuries (and to a lesser extent, other government bonds)
The system uses ledger accounting, there is no physical cash
The only restraint on money creation is bank’s willingness and ability to lend, and the availability of high quality collateral
The Eurodollar system is unregulated and the Federal Reserve and most monetary officials don’t understand its significance
The system creates a constant demand for Treasuries, irrespective of whether USTs have a negative/positive real yield
In a future article I’m going to explore how I think cryptocurrency might play a (limited) role in the Eurodollar system, and possibly solve a few problems along the way.
If you want to learn more about the Eurodollar system you have to turn to Jeff Snider and Hugh Hendry, as they’re the macro commentators who do the best work exposing this network to the light of day.
