What is a Eurodollar?

What is a Eurodollar?

Eurodollar, a United States dollar that has been deposited outside the United States, especially in Europe. Foreign banks holding Eurodollars are obligated to pay in U.S. dollars when the deposits are withdrawn. Dollars form the largest component of all currencies in which such deposits are held and which are generally known as Eurocurrency.

The name originated in the early 1960s when eastern European countries wishing to hold dollar deposits outside the United States deposited them in European banks. Later the market involved many non-European countries.

By accepting a Eurodollar deposit, a bank actually receives a balance with a United States bank. The receiving bank is then able to make dollar loans to customers. Most such loans are used to finance trade, but many central banks also operate in the market.

introduction of Eurodollar

The fact that the eurodollar market is relatively free of regulation means such deposits can pay higher interest. Their offshore location makes them subject to political and economic risk in the country of their domicile; however, most branches where the deposits are housed are in very stable locations.

The eurodollar market is one of the world’s primary international capital markets. They require a steady supply of depositors putting their money into foreign banks. These eurodollar banks may have problems with their liquidity if the supply of deposits drops.

Deposits from overnight out to a week are priced based on the fed funds rate. Prices for longer maturities are based on the corresponding London Interbank Offered Rate (LIBOR). Eurodollar deposits are quite large; they are made by professional counterparties for a minimum of $100,000 and generally for more than $5 million.

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 It is not uncommon for a bank to accept a single deposit of $500 million or more in the overnight market. A 2014 study by the Federal Reserve Bank showed an average daily volume in the market of $140 billion.

Most transactions in the eurodollar market are overnight, which means they mature on the next business day. With weekends and holidays, an overnight transaction can take as long as four days. The transactions usually start on the same day they are executed, with money paid between banks via the Fedwire and CHIPS systems.

Eurodollar transactions with maturities greater than six months are usually done as certificates of deposit (CDs), for which there is also a limited secondary market.

History of the Eurodollar

The origins of the eurodollar can be traced back to the 1960s, where Eastern European countries initially wanted to keep U.S. dollar deposits outside the U.S. and hence deposited them into European banks. Such a dramatic acceleration of foreign capital paved the way for financial innovation in the form of the Eurocurrency market.

The Eurocurrency market encompasses the entire money market for currencies that exist in foreign countries. An early impetus leading to the origin of the market is said to surround exchange controls in 1957. The controls made foreign deposits more attractive since they could be used as credit instruments by non-residents.

In the earlier days, the eurodollar market’s players consisted of European and Far East businesses, which preferred Eurodollars as a way to finance their imports from the U.S. The behavior was partly driven by the benefits that business owners received through cost-saving since lending rates in the eurodollar market were cheaper compared to other alternatives.

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Advantages of Eurodollar

1. Useful for foreign trade

The Eurodollar is considered one of the reasons behind the growth in the international short-term capital market. Also, it is useful for financing foreign trade by enabling traders to import and export through cheaper methods.

2. Greater flexibility

The Eurodollar allows for greater flexibility to adjust cash/liquidity positions for financial institutions.

3. Funding for arbitrage

The Eurodollar helps enhance the extent of funds available for arbitrage.

4. Source of funds for financial institutions

Financial institutions and authorities that are running low on reserves can meet their demands by borrowing from the eurodollar market.

The eurodollar may seem too good to be true with all the benefits it brings. However, there are some traits that can make it not-so-ideal.

Disadvantages of Eurodollar

1. Weakened financial discipline

Naturally, due to the fact that it is unregulated by the home country of the currency, it weakens the banking community’s discipline and reduces the value of the domestic currency. It also speaks to the spending behaviors of citizens, which may now include an increased amount of foreign expenditure due to the ease and convenience of the eurodollar market.

2. Risk of excess credit

Tension can arise from the overextension of the dollar credit by domestic banks and the potential to generate sudden large-scale credit withdrawals in a country.

3. Exchange rate destabilization

The market can cause destabilization by applying pressure to foreign exchange rates and foreign exchange reserves.

How the Eurodollar Market Impacts the Global Financial System

  • The Eurodollar market promotes international monetary cooperation.
  • Spanning the last decade, the world saw a decline in the global liquidity problem correlated with the simultaneous increase in the growth of the eurodollar.
  • The dollar’s position became stronger partly due to an increase in profitable transactions of borrowing operations in the Eurodollar market.
  • The eurodollar market is also a blessing in disguise for many entities, especially for countries with a balance of payments deficit, as they are now able to borrow funds and reduce the potential foreign exchange reserve drain.