International banking lesson 05

44 International Banking LESSON 5 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 Mark

44

International Banking LESSON

5

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

45 Eurodollar Markets

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 $ 2 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

46

1 What is the size of eurodollar market?

……… ………

2 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:

1 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

2 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

3 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 $ 1 million

4 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

47 Eurodollar Markets

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 3 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 1 to 3 basis -points for European bank-dollar CDs and

around 5 basis points for Japanese bank dollar CDs

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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 4 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 Banks- generally 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 5 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

49 Eurodollar Markets

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 2

Fill in the Blanks:

1 Eurodollar volume is pleasured as the deposit liabilities of

banks located outside the United States

2 Trading is most frequent in the sovereign sector, which accounts for about

20 percent of paper outstanding

3 The growth of the market owes a great deal to the fact that it is outside the

control of any

4 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 do 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

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

1 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?

2 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

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 $ 2 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…

51 Eurodollar Markets

2 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 2

1 dollar-denominated

2 Euro commercial

3 National authority

4 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