A Eurodollar refers to a time deposit account that is denominated in U.S. dollars and held in foreign banks. They were originally restricted to the European region, hence the name “eurodollar.” Eventually, several non-European countries were included as destinations for the U.S. dollar deposits, including the Bahamas and Cayman Islands.
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.
The Eurocurrency Market
From an umbrella perspective, the eurocurrency market is responsible for the external lending and borrowing of the world’s most convertible currencies, such as the dollar and pound sterling. Some attributes of the eurocurrency market are as follows:
1. Free of domestic regulations
Let’s take the example of the U.S. dollar. If one keeps U.S. dollar deposits in a foreign bank, say a bank in London, it is by default free of the regulations imposed by the U.S. Federal Reserve Board.
2. Unique operations
Since each transaction occurs in a currency that is not of the originating country, the eurocurrency market’s dollar operations are unique in nature.
3. An indispensable part of the monetary system
Among its benefits is the fact that the eurodollar market features high interest rates and more flexibility on maturities. Furthermore, it is also the largest market for short-term funds.
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.