a brief primer on eurodollars
| stablecoins and the near future of crypto seriesMuch of this is informed by Jeff Snider’s Eurodollars University series 1 . Start there for a deeper dive.
defining eurodollars
Just what are Eurodollars? They are deposit liabilities, denominated in dollars, of banks outside the United States 2
That ^^ is “the” definition from the seminal paper on Eurodollars published by Milton Friedman in 1971.
Let’s break this down:
Recall the core idea behind fractional banking from the first piece in this series: Commercial banks “create” credit money by making loans out of thin air and crediting the value of that loan to the borrower’s account at the bank. This credit to the account makes a deposit liability - a deposit for which the bank is on the hook to pay m0 money at some point.
A eurodollar is simply a USD denominated deposit liability held in a bank “outside” of the United States. “Outside” meaning outside the regulatory environment of the United States. Don’t forget that a bank holding dollar liabilities must itself have an account at the Fed or have an account with a bank that has an account at the Fed. If they’ve got USD deposit liabilities, they’ve somehow got to access cbr’s or physical currency when an account holder wants her money. But having an account at the Fed, or having access to someone else’s account at the Fed does not mean the bank falls under US banking laws. This is an important distinction. It is one of the reasons why banks started using eurodollars.
So how is a eurodollar created? Well, the old school way, per Friedman’s paper, is to take a USD denominated deposit liability that already exists inside of a bank that falls under US banking laws and to transfer that deposit liability to a subsidiary of that US bank that does not fall under US banking laws. This is an intra-bank transfer. To transfer between subsidiaries means no cbr’s change hands. The deposit liability is still linked to the same cbr’s sitting in the same line of the Fed’s digital ledger database. It only means that a line representing a deposit liability is moved from one set of accounting books (the US books) to another set (the non-US set) within the bank’s systems.
This isn’t the only way to create eurodollars. Any bank anywhere in the world - as long as they directly or indirectly have access to m0 - can “create” eurodollars by granting a USD denominated loan.
Why would banks go to the trouble of moving a USD deposit liability outside of US jurisdiction? Simple: profit. Subsidiaries outside of the US can typically create more credit money off of the same amount of “real” deposit liabilities, which means they can pay higher interest rates, thereby attracting more “real” deposits. This motive, of course, assumes that there are economic activities happening outside of the US - geographically and jurisdictionally speaking - that require dollar loans and that these activities have higher yields than those in the US. More on all of this shortly, but that’s the core idea: outside of the US, banks can lend more at higher rates because of fewer rules and more profitable dollar-denominated economic activity.
The drama of the eurodollar has three acts: the rational, the irrational, and the lunacy. The first act was driven by USDs' utility in international trade. The second begins when banks - big, commercial, profit-seeking banks - wade into the eurodollars market like a drunken bull into a china shop. And the third happens when a surplus of eurodollars discover inaccurately risk-rated mortgage backed securities.
act one - the rational: eurodollars enable international trade
In the immediate, messy aftermath of post-WWII, several things were happening. One, the US was beginning its reign as the undisputed hegemon of the world. Two, the economies and currencies of nations recovering from the war were in tatters. Three, as a result, the US economy and its exports were booming. This all translated to lots of people buying lots of stuff with USD.
At the same time, the Bretton Woods conference declared that the “major” post war economies were going to tie their exchange rates to gold and use it to settle trade deals. Since the US controlled 2/3 of the world’s gold, this meant that the dollar was, almost literally, as good as gold. Accordingly, banks started treating the dollar like gold and the dollar came to be considered even safer than it already was - it was already considered to be quite safe.
Gold had long been used to settle trade deals. It would work something like this: The buyer in a trade deal would present the seller with a note that represented some gold he held in a bank. The seller would then give that note to the seller’s bank and the seller’s bank would arrange for the physical gold to be transferred from the buyer’s bank to the seller’s. That gold would then be credited to the seller’s account.
Post Bretton Woods, banks realized it was simpler to settle trade deals with dollars instead of gold. This was due in no small part to the fact that dollars were just logistically easier. If a deal was settled in dollars, no physical gold ever had to be transferred between banks.
The process for facilitating trade deals with dollars was similar to that of gold with an important difference. The buyer would take out a loan for dollars and then transfer those loaned “dollars” to the seller. Once the buyer had sold those goods or achieved some other sort of commercial outcome with the goods, he would pay off the loan. If this transaction happened within the same bank - meaning the buyer’s and seller’s accounts were at the same bank, no m0 would ever change hands. Just as transferring USD deposit liabilities from an onshore to an offshore subsidiary of a US bank required no cbr’s, intra-bank trade settlement required no transfer of cbr’s. It was just moving numbers from one line of a single bank’s own ledgers to another line of those ledgers. If it happened across banks, then the bank would have to make an interbank transfer of cbr’s between the two banks' accounts at the Fed as described in the first post.
The key here was that trade deals started to be settled not with gold and not with dollars but with loans of dollars. This worked well enough for a simple reason: the loans would be paid off. Or, in other words, they would “self-extinguish”. Credit money was temporarily created in these deals but ultimately, it “expired” before it ever entered the broader economy. This idea of self-extinguishment would be thrown out the window when the drunken bull that was big banks (rather than international traders) became the borrowers in these types of loans. More on that later.
This all started happening in the 1960’s, by the way. About the same time, the boom in economic activity of both emerging markets and established markets that had recovered from WWII collided with some ancient US banking regulations. This collision set the stage for banks to enter into and warp the original eurodollar system into a horse of an entirely different color.
act two - the irrational: big banks wade into eurodollars
The irrational act begins with Regulation Q, a relic of the Great Depression. Regulation Q limited the interest rates that banks could pay out on deposits. The underlying thinking was that this would prevent banks from using deposits to engage in risky ventures. In the 60’s and 70’s it also meant that large corporate depositors started to move their money overseas where they could get higher interest rates on their deposits. Putting aside the ceiling on rates created by Regulation Q, it was also true that there were simply higher yielding economic opportunities outside of the US as many of the world’s economies had recovered and were now gaining economic steam post WWII.
US banks, wanting to find ways to recover their lost deposits, which were what enabled them to make loans and therefore make money, took two general paths. The smaller ones started to “finance” their funding through the Fed’s discount window. Bigger banks turned to the Eurodollar markets. I’m not a financial historian but I think it’s not crazy to say that this shift, happening about 40 years before the ‘08 global financial crisis was the beginning of the sequence of events that led to the GFC. And this is one of the reasons why I think eurodollars are so interesting.
Here’s what this change meant: First, US banks began getting part of their funding from overseas. Second, they began counting loans of US dollars - eurodollars - as part of their asset base when deciding how much to lend. Instead of paying interest rates to depositors, they were paying interest on these eurodollar loans.
And here was another important difference: these loans never got paid off. They simply got rolled over. This was the beginning of the overnight market / wholesale money markets mentioned in the previous post. Remember that in the original eurodollar market, the one used for trade deals, eurodollar loans self-extinguished whenever the buyer sold the goods to consumers (or something along those lines) and paid off his eurodollar loan with those proceeds. The self-extinguishment of these loans naturally limited the size of this layer of derivative dollars (aka credit money). Here, though, the loans never extinguished. And so, the number of eurodollars in existence started a growth spurt that would last for decades.
With this, the ground upon which big banks’ businesses were built became shakier. This is worth repeating: Now, loans given by banks were based not just on relatively stable retail deposits but also eurodollar loans. The folks making these short term eurodollar loans were much more sensitive to changes in the economic environment. These were other banks, corporations etc. that counted every bps. This meant that this overnight eurodollar funding was flightier than retail deposits. Your grandparents were less likely to move their deposits from Chase to Wells Fargo for a few bps. The Sovereign Wealth Fund of Norway would shift their funds elsewhere in a heartbeat.
In parallel to banks using eurodollars to fund their US operations yet another trend was happening. Investors all over the world began using US dollars to invest in emerging markets. By doing so, they could get exposure to the high growth of those economies without worrying about those economies' unstable local currencies. In other words, they were able to decouple currency risk from country risk. This further drove up overseas demand for USDs.
On top of this, the network effects of all of this activity and the continued cementing of the perception that dollars were safe and liquid spawned other uses like individuals storing their savings in dollars or using them to pay their family in other countries. This last use case was the beginning of the remittances market you see today; and an important use case for crypto and stablecoins. More on this in the next post.
act three - lunacy: the system eats its tail and calls it dinner
So the system described above is the core of the system that existed up until ‘08. However, in the intervening decades - 80’s and 90’s - some other things happened that supercharged this system. The super-charging is what yielded the lunacy.
You could say that act two describes how the aircraft that was the international banking system went from a propeller-driven thrust system to a jet-powered thrust system. Act three will describe some things like afterburners and other bolt-on’s to the jet-powered thrust system that supercharged it. But these things did not fundamentally change the jet engine that was eurodollar fueled banking operations.
In 1990/91 some changes were made to another banking regulation - this time Regulation D. While banks had been using eurodollars to fund lending operations for a while, the changes to Regulation D reduced restrictions about how much lending and investing could occur on the back of eurodollars. With this, the gap between credit money created and actual m0 possessed by banks that could be used to back up these loans was allowed to get even bigger. In the run up to ‘08 GFC, things reached a point where eurodollars funded MORE of US banking activities than funding obtained domestically via the federal funds rate. Note that banks weren’t really using the Fed’s discount window to fund this overnight money so that’s why I didn’t include it here. Technically, they could have but they chose not to for reasons that are out of scope. So, there is supercharger component number one.
On to supercharger component number two: banks dove into derivatives to “de-risk” their overnight eurodollar funding. Derivatives are basically insurance. So imagine buying insurance on all of this overnight “money” so that if suddenly this overnight money gets more expensive, you’re covered and can still afford to renew your loans at a higher rate the next day, and therefore your business model is not destroyed when rates change.
Bottom line is it was getting easier and easier for banks to get more “assets” (eurodollar loans) against which to create more credit money (and therefore make more money). But there is only so much useful economic activity happening in the world at a given time. So banks began to look further afoot to find homes for all the fresh eurodollar-backed loans they wanted to make that would allow them to keep increasing profits.
One of the homes they found for all of this credit was a relatively new asset: mortgage backed securities. I won’t go into these since they’ve been beaten to death since ‘08. But the key thing here is that, more and more, mbs’s became a major destination for the credit money created on the back of overnight eurodollars. Indirectly, this meant that eurodollars were actually being used to dole out mortgages to under-qualified US home-buyers.
And so, eurodollars continued to become a more and more integral cog in the global financial system. They were used as collateral in a lot of the deals that enabled this system - the derivatives, the overnight loans etc. As such, they figured heavily into the math done to determine whether a bank was solvent or not.
intermission: libor
We’ve discussed discount rate - the rate at which US banks can borrow cbr’s from the Fed at the Fed’s metaphorical “discount window”. We also discussed the federal funds rate - the rate at which banks can borrow cbr’s (aka federal funds) from other banks. The two accomplish the same thing: obtaining a loan of cbr’s. The loan is coming from either the Fed or other banks. It’s time to introduce a third rate: LIBOR - the London Inter-bank Offered Rate. LIBOR is basically the eurodollar equivalent of the federal funds rate. Don’t miss this subtle but key difference: LIBOR is the “offered” rate for a bank to bank loan of eurodollars - not central bank reserves. So ultimately whoever loans you eurodollars needs to get their hands on cbr’s if you actually use that eurodollar loan (aka transfer it out of your account). You, a big drunken bull of a US bank, in taking out this loan are still counting on having access to cbr’s somewhere down the line. The fact that it is the London rate stems from the fact that historically, the market for eurodollar loans was based in London. But people all over the world (including folks in the US) use LIBOR to price out eurodollar loans as well as many other types of loans. So Fed Funds rate is the cost of cbr’s. LIBOR is cost of eurodollars. And both the federal funds rate and LIBOR play a key role in determining banks’ cost of doing business.
back to the third act
So let’s recall the basic banking business model for a second. You take money in - from a depositor, to whom you pay an interest rate - and you loan money out - to a borrower, from whom you receive an interest rate. The difference between those two rates, roughly, drives your profits.
Traditionally, the “cost” of your money was just the interest you paid retail depositors. In the second half of the 20th century, the cost of money became more complex. Now, the cost was not just the interest paid to depositors but also the interest you paid on the overnight loans of dollars you continually rolled over to fund your lending - usually the federal funds rate (if you borrowed cbr’s) or LIBOR (if you were using eurodollars). And remember that we’re talking about almost unconscionable amounts of loans rolling over in these overnight markets. So, the slightest change in rates, a few bps, would have a big impact on banks’ businesses. Also remember that they were pushing everything as close to the envelope as possible, so there wasn’t a lot of cushion to absorb changes in those rates.
And so this was pretty much what the stage looked like pre-‘08 GFC. When people realized mortgage backed securities weren’t as safe as everyone thought, then all of the places in the system where mbs’s and their relatives served as collateral etc. had to be adjusted. But because everything was so tight, that adjustment, even though small in absolute terms, was relatively tectonic. In response to this adjustment, the cost of LIBOR climbed. Then, everything in the system that was financed off of the back of eurodollars and LIBOR - which was a lot of stuff - went haywire. (Lunacy enters, stage right). You know the rest of the story.
QE(urodollars)
Part of the reason why the Fed started QE was because of LIBOR and eurodollars. The Fed can use the discount window to affect the Fed funds rate pretty effectively. But that is the cost of actual cbr’s. LIBOR, on the other hand, is about eurodollars, not cbr’s. So, the Fed didn’t have as powerful and direct of a tool to move LIBOR. In fact, the Fed wasn’t directly involved in eurodollars at all. In response, it began open market operations and the QE program we’ve come to know and love. By buying assets off the open market, it was able to indirectly move LIBOR and help banks continue their operations.
Unfortunately, much of the money that is being put into the economy through open market operations isn’t making it out of banks as loans to small businesses or people. Instead, banks are using it to finance their own investments and, allegedly, fuel the rise of US equity and other markets. The accuracy of these last few statements and the complexity of the interwoven dynamics here is beyond the scope of this article. The key takeaway is: QE is perpetuating the jet-powered thrust system that has been keeping the banking system airborne for many decades but it’s not really helping individuals, at least not directly. This is possibly why the CPI hasn’t jumped as much as some have hoped.
It is in this context that stablecoins have enjoyed a meteoric rise in the last few years. We’ll cover this next - in the third and final post of the series.