44 International Banking LESSON EURODOLLAR MARKETS CONTENTS 5.0 Aims and Objectives 5.1 Introduction 5.2 Origin and Growth 5.3 Eurodollar Market 5.4 Important Features of the Market 5.5 The Size of the Eurodollar Market 5.6 Instruments of the Eurodollar Market 5.7 Creation of Eurodollar 5.8 Let us Sum up 5.9 Lesson End Activity 5.10 Keywords 5.11 Questions for Discussion 5.12 Suggested Readings 5.0 AIMS AND OBJECTIVES After studying this lesson, you should be able to understand: z The growth of the eurodollar market z Different instruments of euro currency markets 5.1 INTRODUCTION Eurodollars are bank deposit liabilities denominated in US dollars but not subject to U.S banking regulations For the most part, banks offering Eurodollar deposits are located outside the United States However since late 1981 non-US residents have been able to conduct business free of US banking regulations at International banking Facilities (IBFs) in the United States Eurodollar deposits may be owned by individuals, corporations, or governments from anywhere in the world, with the exception that only non-US residents can hold deposits at IBFs 5.2 ORIGIN AND GROWTH The origin of this market may be traced back to the, 1920s, when United States dollars were deposited in Berlin and Vienna and were converted into local currencies for lending purposes However, the growth of the Eurodollar market began to gain momentum only in the late 1950s Since 1967, the growth of the market has been very rapid The flow of petrodollars has given in an added momentum in the 1970s The accelerated growth of the market is expected to continue in the eighties The precise size of the Eurodollar market is unknown However, the estimates of the BIS arc acknowledged as the best source Accordingly, its size grew from $ billion in 1960 to $ 256.8 billion in 1969, $ 75.3 billion in 1970, $97.8 billion in 1971 and some $ 131.9 billion in 1972 By the end of 1970s, the volume of the Euromarket was estimated at US $1.2 trillion gross and US $ 650 billion net, i.e., excluding inter-bank positions This was about eight times the size of the market in 1970 By mid-1984 the size of the market reached $ 2,325 billion It has further grown substantially over the years As Prof Venkatagiri Gowda points out, the phenomenal development of the Eurodollar market since the beginning of 1960s may also be viewed from the standpoint of the width, breadth and resiliency of the market The momentum of the development of this market accelerated after 1968, when the international gold and currency problem developed into a recurring crisis every year, and the United States balance of payment deficits supplied additional dollars to the market More and more participants were drawn into the market because of its growing economic efficiency, competitiveness and the sure prospect of gain it confidently held out Besides central banks and financial intermediaries, multinational corporations, Middle Eastern oil firms, developing countries and Communist countries entered the market as participants The centre of the Eurodollar market has spread from London and West European financial centres to other less known places like the Bahamas, Singapore, the Lebanon and Toronto The depth of the market is reflected in the longer terms of loans and the increased channels of obtaining them Since the market is large, efficient and highly competitive, it is highly sensitive too This is reflected in the fluctuations of interest rates, depending on international supply and demand factors 5.3 EURODOLLAR MARKET Originally, dollar-denominated deposits not subject to US banking regulations were held almost exclusively in Europe; hence, the name Eurodollars Most such deposits are still held in Europe, but they also are held at u.s IBFs and in such places as the Bahamas, Bahrain, Canada, and Cayman Islands, Hong Kong; Japan the, Netherlands Antilles, Panama, and Singapore Regardless of where they are held, such deposits are referred to, as Eurodollars Bank in the Eurodollar market, including US IBFs, compete with banks in the United States to attract dollar-denominated funds.-Since the Eurodollar market is relatively free of regulation, banks in the Eurodollar market can operate on narrower margins or spreads between dollar borrowing and lending rates than can banks in the United States This gives Eurodollar deposits an advantage relative to deposits issued by banks operating under US regulations In short, the Eurodollar market has grown up largely as a means of avoiding the regulatory costs involved in dollar-denominated financial intermediation that contributed to the rise of the Eurodollar markets Some of the basic factors are: (i) US financial regulation played a very large role in the creation of the Eurodollar markets, especially Regulation Q (ii) The US balance of payments deficits and to the accumulation of dollars stride the US (iii) The US dollar was the key international currency for trading and for reserve purposes (iv) No reserve ratios were required in many of the countries therefore off-balance sheet funding outside the regulatory controls was possible enabling the establishment 45 Eurodollar Markets 46 International Banking Check Your Progress 1 What is the size of eurodollar market? ……………………………………………………………………………… ……………………………………………………………………………… What are the factors responsible for the growth of eurodollar market? ……………………………………………………………………………… ……………………………………………………………………………… 5.4 IMPORTANT FEATURES OF THE MARKET The important characteristics of the Eurocurrency market are: It is an international market and it is under no national control: The Eurocurrency market has emerged as the most important channel for mobilising and deploying funds on an international scale By its very nature, the Eurodollar market is outside the direct control of any national monetary policy "It is aptly said that the dollar deposits in London are outside United States' control because they are in London and outside British control because they are in dollar." The growth of the market owes a great deal to the fact that it is outside the control of any national authority It is a short-term money market: The deposits in this market range in maturity from one day to several months, and interest is paid on all of them Although some Eurodollar deposits have a maturity of over one year, Eurodollar deposits are predominantly a short-term instrument “The Eurodollar market is viewed in most discussions more as a credit market-a market in dollar bank loans - and as an important accessory to the Eurobond market." Eurodollar loans arc employed for longer-term loans Eurobonds developed out of the Eurodollar market to provide longer-term loans that was usual with Eurodollars These bonds are usually issued by a consortium of bank and issuing houses It is a wholesale market: The Eurodollar market is a wholesale market in the sense that, the Eurodollar is a currency dealt only in large units The size of an individual transaction is usually above $ million It is a highly competitive and sensible market: Its efficiency and competitiveness are reflected in its growth and expansion The resiliency of the Eurodollar market is reflected in the responsiveness of the supply of, and demand for, funds to changes in the interest rates and vice versa 5.5 THE SIZE OF THE EURODOLLAR MARKET Eurodollar volume is pleasured as the dollar-denominated deposit liabilities of banks located outside the United States For example the Bank for International Settlements (BIS) defines and measures Eurodollars as dollars that have been acquired by a bank outside the United States and used directly or after conversion into another currency for lending to a non bank customer perhaps after one-Off more redeposit from one bank to another The, sum of all dollar is denominated liabilities of banks outside the United States measures the gross size of the Eurodollar market For some purposes, it is useful to net some interbank deposits but of the gross to arrive at an estimate of Eurodollar Deposits held by original suppliers to the' Eurodollar market Roughly speaking, to construct the net size measure, deposits owned by banks in the Eurodollar market are netted out But deposits owned by banks located outside of the Eurodollar market area are not netted-out because these banks are considered to be original suppliers of funds to the Eurodollar market For still other purposes, such as comparing the volume of deposits created in the Eurodollar market with the US monetary aggregates, it is useful to further net out all bank- owned Eurodollar deposits Doing so leaves only the non bank portion of the net size measure, or what might be called the net-net size of the Eurodollar market The most readily accessible estimates of the size of the Eurodollar market were compiled by Morgan Guaranty Trust Company of New York and, reported in its monthly bank letter, World Financial Markets Morgan’s estimates included data compiled by the BIS However, Morgan's estimates were somewhat more comprehensive Morgan reported estimates of the size of the entire Eurocurrency market based roughly on all foreign-currency liabilities of banks in major European countries, nine other market areas, and U.S IBFs Morgan stopped publishing its Euromarkets data in 1988 As of March 1988 Morgan estimated the gross size of the Eurocurrency market at $4,561 billion; the net size was put at $2,587 billion Morgan also reported that Eurodollars made up 67 percent of gross Eurocurrency liabilities, putting the gross size of the Eurodollar market at $3,056 billion No net size for the Eurodollar market was given However, 67 percent of the net size of the Eurocurrency market yields $1,733 billion as an approximate measure of the net size of the Eurodollar market M2 is the narrowest US monetary aggregate that includes some Eurodollar deposits M2 includes overnight Eurodollar deposits held by US residents other than depository institutions and money market funds at branches of US banks worldwide As of May 1991, M2 measured $3,396 billion; its Eurodollar component was$8 billion This comparison shows clearly that Eurodollar deposits account for a relatively small portion of monetary assets held by US residents 5.6 INSTRUMENTS OF THE EURODOLLAR MARKET The overwhelming majority of money in the Eurodollar market is held in fixed-rate time deposits (TDs) The maturities range from overnight to several years, although most are from one week to six months Eurodollar time deposits are intrinsically different from dollar deposits held at banks in the United States only in that the former are liabilities of lBFs or of banks located outside the United States The bulk of Eurodollar TDs interbank liabilities They pay a fixed, competitively determined rate of return Another important Eurodollar instrument is the Eurodollar certificate of deposit (CD) Essentially a Eurodollar CD is a negotiable receipt for a dollar deposit at a bank located outside the United States or in a US IBF From their introduction in 1966, the volume of Eurodollar CDs outstanding reached roughly $5 billion at the beginning of 1980: By late 1990, Eurodollar CD volume was around $130 billion The 1990 elimination of the percent reserve requirement on non-personal time deposits and CDs in the United States has made the Eurodollar CD market a bit less active In 1992, volume had fallen to around $116 billion Recently, fixed-rate, three-month Eurodollar CDs have yielded approximately 10 basis points below the three-month London Interbank Offered Rate (LIBOR) UBOR is the rates at which major international banks are willing to offer term Eurodollar deposits to each other An active secondary market allows investors to sell Eurodollar CDs before the deposits mature Secondary market makers' spreads for short-term fixed-rate CDs have been to basis -points for European bank-dollar CDs and around basis points for Japanese bank dollar CDs 47 Eurodollar Markets 48 International Banking Eurodollar CDs are issued by banks to tap the market for funds and are commonly issued in denominations of from $250,000 to $5 million Some Eurodollar CDs, called Tranche CDs, are issued in very large denominations but marketed in several portions in order to satisfy investors with preferences for smaller instruments The latter are issued in aggregate amounts ($10 million to $30 million and are offered by banks to individual investors in $10,000 certificates, with each certificate having the same interest rate, issue date, interest payment dates, and maturity In the late 1970s Eurodollar floating-rate CDs (FRCDs) and Eurodollar floating-rate notes (FRNs) came into use as means of protecting both borrower and lender against interest rate risk By making their coupon payments float with market interest rates, these floaters stabilize the principal value of the paper The market for FRCDs is no longer active The volume of FRNs outstanding fell from $125 in 1986 to $116 in 1990 Eurodollar FRNs have been issued in maturities from to 20 years, with the majority of issues concentrated in the five- to seven-year range Eurodollar FRNs tend to be seen as an alternative to straight fixed-interest bonds, but they can in principle be used like FRCDs Eurodollar FRNs have been issued primarily by banks and sovereign governments FRNs issued by governments are not Eurodollars proper since they are not bank liabilities Strictly speaking, they should be referred to as Eurodollar instruments together with the NIFs and Euro commercial paper discussed below: Eurodollar FRCDs and FRNs are both negotiable bearer paper The coupon or interest rate on these instruments is reset relative to the corresponding LIBOR every three or six months The rate is set below LIBOR for sovereign borrowers and above for US banks Yields on Eurodollar FRNs range from 1/8 percent under the London Interbank Bid Rate (LIBID) up to LIBOR To determine LIBOR for Eurodollar FRNs, "the issuer chooses an agent bank who in turn polls three or four Reference Banksgenerally the London offices of major international banks Rates are those prevailing at 11:00 a.m London time two business days prior to the commencement of the next coupon period." A secondary market exists in FRNs The spread quoted on FRNs in the secondary market is generally 10 cents per $100 face value for the liquid sovereign issues Other spreads are quoted on an indicative basis and are somewhat higher Note Issuance Facilities (NIFs) became a significant Eurodollar instrument in the mid-1980s A NIF is a medium-term, usually five- to seven-year arrangement between a borrower and an underwriting bank under which the borrower can issue short-term, usually three- to six-month, paper known as Euro-notes in its own name Under such an arrangement, the underwriting bank is committed either to purchase any notes the borrower cannot sell or to provide standby credit at a predetermined spread relative to some reference rate such as LIBOR Underwriting fees are paid on the full amount of the line of credit, regardless of the amount currently drawn The fee is basis-points for top borrowers and ranges up to 15 basis-points for worse credit risks The notes are issued with face amounts of $100,000, $500,000, or more Well-regarded borrowers can issue Euro-notes at around LIBID Top borrowers can issue at yields 1/16 or 1/8 percentage point below LIBID Euro-notes are comparable investments to Eurodollar CDs When the market initially matured around 1985, non bank corporate borrowers accounted for roughly 60 percent of NIFs arranged Most borrowers were from countries in the Organisation for Economic Co-operation and Development As of April 1986, about $75 billion of NIFs had been arranged, with only an estimated $-10 to $15 billion having been drawn Most paper was placed with smaller, non-underwriter banks In 1985, about one-third or more of placements may have been with non bank investors, including money market funds, corporations, insurance companies, wealthy individuals; and central banks Since mid-1984, facilities similar to NIFs have been arranged without underwriting commitments In the second half of 1985, new non-underwritten agreements equaled new NIFs arranged Non-underwritten become much like US commercial paper programmes: note issuance has been separated from the standby a arrangement, notes are issued in shorter odd maturities, and notes can be marketed quickly Under such an arrangement, a bank is simply a marketing agent Euro-notes issued under such conditions are known as Euro commercial paper The volume of newly arranged NIFs declined from $40 billion in 1985 to $4 billion in 1990, while Euro commercial paper outstanding rose from $17 billion in 1986 to $70 billion in 1990; recently strengthened risk-based capital requirements have, in part, induced the shift to Euro commercial paper because they have raised the regulatory cost associated with NIPs Euro commercial paper yields range from LIBID minus 25 basis points for top-rated sovereigns to LIBOR plus 3b for low rated corporations For most US corporations, the US commercial paper market probably remains a cheaper source of funds than Euro commercial paper For some non-US corporations, however, Euro commercial paper may be as cheap as US commercial paper because of the premium that foreign issuers pay in the US commercial paper market Like the US commercial paper market, the secondary market for Euro commercial paper is relatively underdeveloped If a client needs to sell paper before maturity he will almost always sell it to the dealer who sold him the paper initially Any trading usually occurs in the first few days after the paper is issued Trading is most frequent in the sovereign sector, which accounts for about 20 per cent of Euro commercial paper outstanding Check Your Progress Fill in the Blanks: Eurodollar volume is pleasured as the deposit liabilities of banks located outside the United States Trading is most frequent in the sovereign sector, which accounts for about 20 percent of paper outstanding The growth of the market owes a great deal to the fact that it is outside the control of any Euro-notes issued under some conditions are known as Euro 5.7 CREATION OF EURODOLLAR Eurodollar markets are well organised, very efficient, and very large They serve a number, of valuable purposes for multinational business operations Eurodollars are a convenient money market device for multinational firms to hold their excess liquidity Eurodollars are a major source of short-term loans to finance corporate working capital needs and foreign trade Many multinational companies and governments have learned to employ the Eurodollar market as readily as they the domestic or banking system The major sources of Eurodollars are (1) the growing dollar reserves of oil-exporting countries, (2) foreign governments or businessmen who prefer to hold dollars outside the United States, (3) foreign banks with dollars in excess of current needs, and (4) multinational companies with excess cash balances Since the 1974 oil crisis, oil-exporting countries have had enough leverage on the worldwide oil supply to in1poseamajor price escalation As a result, the Middle East, where more than half of the world's known oil reserves are located, has acquired enormous economic wealth and has become the important source of Eurodollars Once Eurodollars come into existence, they can create themselves through the lending and investing activities of commercial banks T-accounts may be used to illustrate such Eurodollar creation 49 Eurodollar Markets 50 International Banking 5.8 LET US SUM UP This lesson focuses on Eurodollars, which are bank deposit liabilities denominated in US dollars but not subject to US banking regulations For the most part, banks offering Eurodollar deposits are located outside the United States However since late 1981 non-US residents have been able to conduct business free of US banking regulations at International Banking Facilities (IBFs) in the United States Eurodollar deposits may be owned by individuals, corporations, or governments from anywhere in the world, with the exception that only non-US residents can hold deposits at IBFs 5.9 LESSON END ACTIVITY List the major factors that are responsible for the growth of the international bond market Indicate which of these factors (or other considerations) explain the large number of innovations in this market 5.10 KEYWORDS Agency: Resembles a full-fledged bank in every respect Correspondent Banking: An informal linkage between banks in different Consortium Banks: Joint ventures of the large commercial banks Global Custodians: Possessions of foreign securities for safekeeping, collect dividends, or offer up coupons and handle stock, right issues, tax reclamation and so on Multinational Banking: Location and ownership of banking facilities in a large number of countries and geographic regions 5.11 QUESTIONS FOR DISCUSSION Distinguish between a Eurobond and a foreign bond List the major participants in this market Why does the share of developing countries in this market remain fairly modest? Define (a) a multiple-currency Eurobond, (b) a dual-currency convertible bond, and (c) a floating-rate Eurocurrency note Explain in each case the distribution of risk (the exchange rate risk or the interest rate risk between the lender (investor) and the borrower (issuer) Check Your Progress: Model Answers CYP 1 The precise size of the Eurodollar market is unknown However, the estimates of the BIS arc acknowledged as the best source Accordingly, its size grew from $ billion in 1960 to $ 256.8 billion in 1969, $ 75.3 billion in 1970, $97.8 billion in 1971 and some $ 131.9 billion in 1972 By the end of 1970s, the volume of the Euromarket was estimated at US $1.2 trillion gross and US $ 650 billion net, i.e., excluding inter-bank positions This was about eight times the size of the market in 1970 By mid-1984 the size of the market reached $ 2,325 billion It has further grown substantially over the years Contd… Some of the basic factors are: (i) US financial regulation played a very large role in the creation of the Eurodollar markets, especially Regulation Q (ii) The US balance of payments deficits and to the accumulation of dollars stride the US (iii) The US dollar was the key international currency for trading and for reserve purposes (iv) No reserve ratios were required in many of the countries therefore off-balance sheet funding outside the regulatory controls was possible enabling the establishment CYP dollar-denominated Euro commercial National authority Commercial paper 5.12 SUGGESTED READINGS C Jeevanadam, Foreign Exchange Management Levi, International Finance Ian H Giddy, Global Financial Markets Rupnaryan Bose, Fundamentals of International Banking, Macmillan India Ltd Vyuptakesh Sharan, International Financial Management, Prentice Hall of India ICFAI University Press, International Banking B.K Chauduri, O P Agrarwal, A Textbook of Foreign Trade and Foreign Exchange, Himalaya Publishing House 51 Eurodollar Markets ... Eurodollar Markets 50 International Banking 5.8 LET US SUM UP This lesson focuses on Eurodollars, which are bank deposit liabilities denominated in US dollars but not subject to US banking regulations... Exchange Management Levi, International Finance Ian H Giddy, Global Financial Markets Rupnaryan Bose, Fundamentals of International Banking, Macmillan India Ltd Vyuptakesh Sharan, International Financial... since late 1981 non-US residents have been able to conduct business free of US banking regulations at International Banking Facilities (IBFs) in the United States Eurodollar deposits may be owned