The Eurodollar

One of the more obscure and seldom-discussed levers of international finance is the Eurodollar. When the U.S. dollar assumed status of global reserve currency after the Bretton Woods system had taken hold in the years following World War II, offshore dollar markets developed to meet demand for dollars in trade. This included European banks with dollar denominated accounts and American banks located inside of Europe with dollar accounts. Morgan Guaranty Trust Company in New York, for instance, had branches in Europe that offered Eurodollar accounts. Serious investors should understand the basic functioning of the wholesale Eurodollar market and its impact on financial markets.

A bankers acceptance might be considered a predecessor to the Eurodollar. A bankers acceptance is a time draft on a deposit and a bearer instrument like a cashier’s check. It has been verified that funds are in the account and available for withdraw, guaranteed up front. Like a CD, it has a maturity and pays interest. Bankers acceptances date back to the Middle Ages, when merchants from different parts of the world didn’t trust each other, so an agreement was worked out where a bank that both parties trusted would provide means of settlement. An interbank market denominated in sterling developed in the 18^th and 19^th centuries and bankers acceptances traded on an organized exchange in London. As the United States started to assert itself in the 20^th century, dollar-denominated bankers acceptances grew in popularity. In its early days, the Federal Reserve bought and sold bankers acceptances, making markets where London couldn’t or wouldn’t.

A Eurodollar is not a currency or money per se. A Eurodollar is a time-deposit. What started out in Europe eventually expanded to include all dollar-denominated deposits overseas, but still called “Eurodollars” by convention. There are two parts to the Eurodollar: a bank liability and the underlying Federal Reserve note that more or less serves as a monetary base. Unlike bankers acceptances, however, Eurodollars are unsecured.

In a 1971 paper published by the Federal Reserve Bank of St. Louis entitled, “The Euro-Dollar Market: Some First Principles,” Milton Friedman concluded that Eurodollars were accounting entries from “a bookkeeper’s pen…short-term obligations to pay dollars” and “obligations by banking offices outside the U.S.” (i.e. Morgan Guaranty), which meant the “market” was I.O.U.s trading back and forth that acted as dollars. It became a parallel banking system operating in the shadows of normal money flows. The Eurodollar relief valve enhanced overall dollar liquidity without adding dollars into circulation. As Bretton Woods faltered, the Eurodollar complex replaced bankers acceptances.

Now the Eurodollar is unravelling.

Economist Robert Triffin pointed out that in order to facilitate the global reserve currency, a nation as a matter of policy must run balance of payments (current account) deficits, which is de-facto capital flight. The Eurodollar is an ad hoc, makeshift contraption that evolved after dollars started pouring into the Marshall Plan and Japan, Inc. As the Soviet Union ramped up crude oil production in the new dollar-centric world, European banks gladly opened their arms to the Russian petro-state. For obvious reasons New York would not be a safe place to park oil profits. The Bank of England included Moscow Narodny Bank (MNB) in its network of dealers and protected it even after the Cuban Missile Crisis.

As post-war economies grew, the United States would not be able to sustain deficits necessary to keep up with global economic growth, so stress would build up in the system. There are economic repercussions with perpetual trade deficits and there is a confidence boundary with endless quantitative easing. A currency can stand only so much intervention.

The U.S. dollar was the top performer in the 2018 Wall Street Journal Dollar Index, finishing up 4.3%. In reality, though, the dollar is strong not because America is so great. The dollar is strong because there are not enough of them.

“The rising dollar doesn’t happen in a straight line. It occurs in these various episodes. Every time there is this dollar event, another part of the Eurodollar system gets knocked offline. Some form of capacity, whether it’s geographic or type of derivatives after each of these crises, it comes offline never to return. The overall impact has been something like a ratchet effect. The global economy is further and further pressured after each time. There is no recovery in the dollar system, which is I think tells us a great deal about why there is no recovery in the economy,” says Jeffrey P. Snider, head of Global Investment Research at Alhambra Investments.

Soaring budget deficits mean more dollars required to fund government largesse, while the Fed’s quantitative tightening removes U.S. dollars from the global economy, causing a “dollar shortage.” The Eurodollar breakdown is endemic of this. To add confusion to an already fragile artifice, Eurodollar futures are settled in Libor, which is also going away.

Dedollarization is happening the world over, with Russia and Iran setting up payment systems outside the dollar and a new oil contract in Shanghai denominated in yuan. Sanctions and tariffs have consequences. Change in this scale and magnitude in a reserve currency regime has only happened once in modern times. When the dollar replaced pound sterling, the world was in disarray. As the dollar fades, we may see more than just a trade war.