1

The Eurocurrency Market9A�

Prices and PoliciesSecond Edition ©2001

Richard M. Levich

International Financial Markets

Chap 9 (A), p. 2Prof. Levich International Financial Markets

Overview

� Historical Overview� The Origins of Supply and Demand for Offshore

Banking� Onshore Banking Regulations Boost the Offshore

Market� The Offshore Markets Endure� Growth of the Eurocurrency Market

2

Chap 9 (A), p. 3Prof. Levich International Financial Markets

The Eurocurrency Market

� The Eurocurrency market is the market for deposits placed under a regulatory regime different from the regulations applied to deposits used to execute domestic transactions.� US$ in London, £ in Paris, and US$ in NY IBFs

� It owes its existence to differences in national financial regulation combined with declining barriers to international capital movements.

� In effect, it is a parallel market in competition with the traditional domestic market.

Chap 9 (A), p. 4Prof. Levich International Financial Markets

Sectors of the International Money Markets

US$ £

Onshore

Offshore

U.S. bank depositU.S. Treasury bills

and bondsU.S. corporate

bonds

U.K. bank depositU.K. government

bondsU.K. corporate

bonds

Euro-$ depositEuro-$ bond

(corporate andsovereignissuers)

Euro-£ depositEuro-£ bond

(corporate andsovereignissuers)

Currency Dimension

RegulatoryDimension

3

Chap 9 (A), p. 5Prof. Levich International Financial Markets

The Origins of Supply and Demand forOffshore Banking

� The Eurocurrency market evolved through a combination of forces.

� The supply and demand for Eurodollars had always been present. The innovation came in the mid-1950s when banks elected to lend these funds within Europe rather than invest them in the U.S. money market.

� The demand for Eurodollars further multiplied when the Bank of England restricted the external use of sterling in 1957.

Chap 9 (A), p. 6Prof. Levich International Financial Markets

Onshore Banking RegulationsBoost the Offshore Market

� Under Regulation Q, the Federal Reserve established ceilings on the interest rate that banks could pay on deposits.

� To reduce the U.S. capital outflow, more regulations were imposed in the 1960s:� The Interest Equalization Tax (IET) taxes U.S.

purchases of foreign securities.� The Foreign Credit Restraint Program limits the

volume of bank lending with foreigners.

4

Chap 9 (A), p. 7Prof. Levich International Financial Markets

Onshore Banking RegulationsBoost the Offshore Market

� However, these regulations only further encouraged borrowers to investigate the Eurocurrency markets.� Provided a “cushion” of support

� Regulations removed in 1974 with advent of floating� But offshore markets endured, even prospered� Illustrates the “hysteresis effect,” whereby some

business practices persist even though fundamentals have changed – logic: changing back is costly

Chap 9 (A), p. 8Prof. Levich International Financial Markets

Onshore Banking RegulationsBoost the Offshore Market

� European governments also experimented with capital controls in the 1970s.� Both Germany and Switzerland imposed regulations

to try to limit the nonresident demand for their currencies.

� Similarly, these regulations helped to promote the non-dollar segments of the Eurocurrency market.

5

Chap 9 (A), p. 9Prof. Levich International Financial Markets

Growth of the Eurocurrency Market

� As in the onshore markets, funds are deposited, lent, re-deposited, and re-lent in the Eurocurrency market.

� The market has grown from essentially zero in 1960 to roughly $9.5 trillion on a gross basis and $5.5 trillion on a net basis in 1999.

� The U.S. dollar is the main currency, while Europe is the dominant region for Eurocurrency deposits.

Chap 9 (A), p. 10Prof. Levich International Financial Markets

Figure 9.2Dimensions of the International Banking Market

Total of Offshore Deposits and Share Denominated in US$

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999

Bill

ions

of U

S$

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%P

erce

ntag

e of

Gro

ss

Gross Size Net Size US$ Share (See Right Scale)

6

Chap 9 (A), p. 11Prof. Levich International Financial Markets

Figure 9.3Euromarket Deposits By Currency

(Percentage of Deposits Across All Reporting Countries)

0%

10%

20%

30%

40%

50%

60%

US$ Euro Japanese Yen UK Pound Swiss Franc Other

1990 1993 1996 1999Data for 1990, 1993 and 1996 include DM, FFr and ECU only

Chap 9 (A), p. 12Prof. Levich International Financial Markets

The Offshore Markets Endure

� Even though many of the regulations that initially fostered the market had since been abolished, the Eurocurrency markets have continued to grow and prosper.

� Today, we describe the innovation that permits the Eurocurrency market to sustain its existence as “unbundling” - taking the exchange risk of one currency and combining it with the regulatory climate and political risk of another financial center.