The Eurocurrency Market 99 Prices and Policies Second Edition ©2001 Richard M. Levich International Financial Markets McGraw Hill / Irwin

The Eurocurrency Market9

Prices and Policies

Second Edition ©2001

Richard M. Levich

International Financial Markets

McGraw Hill / Irwin

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McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

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

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Overview

Pricing Of Eurocurrency Deposits and Loans Pricing in the Case of One Currency and Two

Financial Centers Can Offshore and Onshore Markets Coexist? The Impact of Capital Controls and Taxes Market Share and Pricing in Competing Offshore

Centers The General Case with Many Currencies and Many

Financial Centers

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Overview

Policy Matters - Private Enterprises Concerns of Depositors Concerns of Borrowers

Policy Matters - Public Policymakers Offshore Markets and Macroeconomic Stability Could the Offshore Markets Expand Indefinitely? Approaches to Regulating Offshore Markets Competing for Markets: U.S. Policy Initiatives Offshore Markets: European Policy Concerns

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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.

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.

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Sectors of the International Money Markets

US$ £

Onshore

Offshore

U.S. bank deposit U.S. Treasury bills

and bonds U.S. corporate

bonds

U.K. bank deposit U.K. government

bonds U.K. corporate

bonds

Euro-$ deposit Euro-$ bond

(corporate andsovereignissuers)

Euro-£ deposit Euro-£ bond

(corporate andsovereignissuers)

Currency Dimension

RegulatoryDimension

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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.

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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.

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However, these regulations only further encouraged borrowers to investigate the Eurocurrency markets.

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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.

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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.

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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.

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Pricing ofEurocurrency Deposits and Loans

Consider the case of one currency (the U.S. dollar) and two financial centers (New York and London).

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In the onshore market ...

Quantityof Funds

InterestRates

D

The demand (D ) for funds depends on the required rate

of return on availableprojects,

S

while the supply (S )of funds depends on

individuals’ ratesof time preference.

A

In the absenceof transaction costs,

the equilibrium is at A.

X

When banks incur costs X,

RD

RL

Q

equilibrium deposit rate = RD, lending rate = RL,

market size = Q.

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Since RD can be earned in the onshore market, the supply curve to the offshore market (S* )

will begin at RD.

In the offshore market ...

S*

D*

Eurobanks incur cost X* < X ,

X*

Quantityof Funds

InterestRates

S

D

A

RD

RL

Q

X

* *resulting in offshore deposit

rate RD, lending rate RL, market size Q*.

RL

RD

*

*

Q*

Similarly, the demand curve for

offshore funds (D*) must begin at RL.

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The relationships among onshore and offshore interest rates are : DDLL RRRR **

In other words, for US$ :

New York lending rate (“Prime”)

London Interbank

Offered Rate (LIBOR)

London Interbank Bid Rate (LIBID)

New York deposit rate> > >

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Onshore and Offshore Deposit and Borrowing RatesPercentage per Annum as of June 20, 2000

CanadaEuro AreaJapanSwitzerlandUnited KingdomUnited States

7.50 NA1.3754.757.009.50

5.90634.53130.18753.43756.18756.8125

5.81254.43750.09383.31256.03136.6875

3.703.040.033.296.005.99

PrimeLending

Rate(RL)

OffshoreBorrowing

Rate: LIBOR(RL)*

OffshoreDeposit

Rate: LIBID(RD)*

OnshoreDeposit

Rate(RD)

Note: Prime lending rates may not be comparable as lending practices may vary across countries. LIBID, LIBOR, and deposit rates are for three-month maturities.

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Can Offshore and Onshore Markets Coexist?

If the offshore market provides a similar service at a lower cost, what prevents all onshore transactions from migrating there? Offshore depositors bear the additional risk of

exchange controls or taxes, plus the inconvenience of having deposits outside their home country.

For borrowers, size and credit quality may act as barriers that restrict some firms from access to the offshore market.

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The Impact of Capital Controls and Taxes

When capital controls are present, the inequality may be affected.

DDLL RRRR **

When there are controls on the movement of funds into the onshore market, it is possible that .

DD RR *

When interest rate ceilings or central bank lending guidelines lead to a shortage of funds, borrowers may be prepared to pay .

LL RR *

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Market Share and Pricingin Competing Offshore Centers

Consider the case of one currency (the U.S. dollar) and several offshore centers (London, Frankfurt, Singapore, and Beijing).

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Market Share and Pricingin Competing Offshore Centers

D*

RL

Quantity of Funds

InterestRates SBeijing

SSingapore

SFrankfurt

SLondon

RD

**

**

8.25%

8.00%

QA

X*

The demand for offshore dollars

The supply of funds to each offshore center depends on the assessed costs

and risk of using the center.

Suppose each center

incur cost X* = 0.25%.

QD QC QB

Once the most efficient and least

risky center has set the price, the others

must follow suit.

Then for London, deposit rate = 8.00%, lending rate = 8.25%,

market size = QA.

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The General Case with Many Currencies and Many Financial Centers

US$

UK£

€

SFr

S$

Real

NY US$NY IBF US$

NY IBF £

NY IBF €

NY IBF SFr

London US$

Frankfurt US$

Zurich US$

SingaporeUS$

London £

Frankfurt £

Zurich £

Singapore£

London €

Frankfurt €

Zurich €

Singapore€

London SFr

Frankfurt SFr

Zurich SFr

SingaporeSFr

London S$

Zurich S$

SingaporeS$

Rio Real

UnitedStates

UnitedKingdom Germany Switzerland Singapore Brazil

Onshore market Offshore market

regulatory costs and political risk vary

exchangerisk vary

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Arbitrage and Interest Rate Parity

The interest rate differential between an onshore market and an offshore market has been analyzed using a loanable funds approach.

Arbitrage and regulatory competition should keep the offshore interest rates for a single currency nearly equal.

The interest rate differential between offshore instruments should conform to the interest rate parity condition.

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Policy Matters - Private Enterprises

Depositors are concerned about the riskiness of offshore deposits. If a dispute arises between the depositor and the

bank in a cross-border transaction, it is difficult to know in advance which country will claim jurisdiction and which legal precedents apply.

A further complication concerns whether the offshore bank is organized as a separate subsidiary or a branch of the parent bank.

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The simple distinction between assets and liabilities in banking frequently offers a useful guide for sorting out the complex legal issues that arise in a cross-border banking dispute.

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Borrowers are primarily concerned about the costs of borrowing onshore versus offshore. Note that the reference rate (prime or LIBOR) is

only one element in the overall cost of bank funding.

Borrowers may need to post some form of collateral (often in the form of compensating balances), pay a multiple of the reference rate or an additional x %, and/or put forward a lump-sum up-front fee.

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Borrowers also need to deal with the interest rate risk that is associated with floating-rate Eurocurrency loans. Borrowers may choose to hedge this risk using

Eurodollar interest rate futures contracts or interest rate swaps.

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Policy Matters - Public Policymakers

For some offshore financial centers, the rise of the Eurocurrency market has been an important boost to employment and economic activity.

For some major industrial countries, the rise was perceived as a threat to their ability to control macroeconomic conditions within their borders, and perhaps even as a threat to the fundamental safety and soundness of the financial system.

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With the passage of time, most of these fears have been put to rest, either through new policy agreements or a better understanding of how the Euromarkets operate. Even though the Eurocurrency market has no

required reserves, the interaction of supply and demand for funds means that “the specter of uncontrolled credit expansion, made possible by an infinite [deposit] multiplier, is illusory.”

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The Eurocurrency markets are now acknowledged as being fully competitive with the traditional onshore banking system.

Policymakers have thus opted to factor in the Euromarkets when setting domestic monetary and financial policies. Eurocurrency interest rates are closely linked to

those in the domestic money markets of the same currency because the two kinds of deposits are reasonably close substitutes for each other.

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In the Basle Concordat (1974), the United States and 30 other countries agreed to assume lender-of-last-resort responsibility for their offshore banks.

In 1980, the Bank for International Settlements (BIS) announced an agreement among central banks requiring commercial banks headquartered within their territories to consolidate their worldwide accounts.

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In some cases, policymakers have elected to adapt their local regulations to compete head-on with the Euromarkets too. In 1981, the Federal Reserve Board amended its

regulations to allow the creation of International Banking Facilities (IBFs).

In effect, the IBF legislation creates an offshore banking environment located physically within the United states, although there are import restrictions on their operations.

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To create a level playing field in financial services, the European Union (EU) has sought to harmonize rules on withholding taxes and the disclosure of interest paid to depositors and shareholders. Such a policy will be detrimental to Luxembourg,

which generates 20% of its GDP from its attractive financial services. But there can also be a wider impact on the cost of capital for EU firms.

Documents

The Eurocurrency Market 99 Prices and Policies Second Edition ©2001 Richard M. Levich International Financial Markets McGraw Hill / Irwin