This is the first part of a series of articles (I don’t know how many, I’m not done yet) designed to explain what is easily THE most important, albeit poorly understood (even by professionals) market on this ball of dirt.
Eurodollars: What Are They?
To best explain what Eurodollars are we start with the English language.
You see, while English belongs to the Brits it is at the same time the undisputed, undefeated heavyweight champion of the world’s languages. You can be in Marrakesh, Ulan Bator, or Shanghai, and buy yourself a cold beer, swear at a taxi driver, and discuss the weather with a lady called Mei at the train station – all without changing language once.
Sure you may have to strain your ears to understand Singlish in Singapore, and Texans have their own version of most everything, so why not English? Australians always sound like they’ve had too much to drink (which is entirely possible), and at the speed that Kiwis talk it’s no wonder they were exiled to live in a land with more cattle than humans. Hell, even in the birthplace of the English language you’d be found scrunching your face, straining your ears, and begging for sign language instead when conversing with a Geordie. And heaven forbid you find yourself in a pub full of drunken Glaswegians.
Still, English is the grease in the cogs of global communications and so it is with dollars in global finance.
Dollar deposits in their birthplace (US) are well, just dollars. Dollar deposits outside of the US are like Singlish or Ingrish and the dozens of variations across the globe. It’s the same language just in a different place. Just as dollar deposits outside of the US are still dollars.
So eurodollars are essentially all those dollar deposits outside of the US banking system. They are NOT nor have ANYTHING to do with that ridiculous monetary experiment called the euro which wasn’t yet a twinkle in the eye of European bureaucrats, let alone a bump in the womb of Europe, when eurodollars first came into existence.
Eurodollars got their name originally from US dollar deposits in European banks, and in fact their origins date back to the communist days when the Ruskies and Chinese kept dollar deposits abroad (non-US banks) for fear of seizure. Today, however, they are dollar deposits in any bank outside of the US. So dollar deposits in Tokyo, Moscow, and London are all part of the eurodollar system. They are actually even more than simple dollar deposits, which I’ll come to in a bit, but I don’t want to confuse you with what is an incredibly complex market, so let’s do this one step at a time.
What’s It Got to Do With Europe and the Euro Currency?
The term “euro” in eurodollar has as much to do with the euro currency, or the European Union, as peanut butter has to do with the solar system – nothing. You can, for example, have euroeuros or euroyen and these would be euro deposits outside of the EU and euroyen would similarly be yen deposits outside of Japan. Got it?
What’s important to understand is that the eurodollar system is THE biggest source of global funding, bar none. Nobody knows for sure how large it is as it’s basically a large unregulated financing system with thousands of participants globally. But we do know that the eurodollar futures market on the CME is larger than S&P futures, larger than oil futures, larger, in fact, than the 10-year bond futures. It’s estimated over 90% of international trade is financed through the eurodollar market. As Trump would say: it’s yuuuge!
In fact, when cash settled eurodollar futures contracts were introduced to the CME in 1981 it was immediately the largest trading pit ever.
That so few investors know about this enormous market, its importance, and relevance is frankly pretty shocking.
Understanding the eurodollar market goes a long way to understanding why, despite the greatest monetary intervention we’ve ever seen by central banks, we’ve remained in a contractionary environment. I, for one, learned precious little about eurodollars at university, and I know it’s only lightly covered in MBA programs and the CFA which is simply mind boggling to me. But then I don’t make up the syllabus and I’ve always said college is a waste of valuable time.
Our Global Financing System: Hidden in Plain Sight
The eurodollar system is a global financing system regulated by no one, influenced by many, and directly or indirectly affecting every asset price globally. Think of it as a deposit and loan market for offshore dollars. It affects asset prices because it is the wholesale financing system most used in the world. To be clear: there exist wholesale financing in other currencies (the eurocurrency market) but the dollar accounts for an estimated 75% of the eurocurrency market. It is the big Daddy.
It is a critical component to how banks fund and manage their liability structures. It’s also worth pointing out that the eurodollar market is almost entirely a cashless market. It is for simplicity sake, banks’ balance sheets.
The advent of technology in finance has allowed for real time matching of assets and liabilities across financial institutions and the balancing of what are essentially banks’ balance sheets enacted with eurodollars. It is to a certain extent as close to a virtual currency as a real virtual currency like Bitcoin. Very efficient, close to instantaneous, and, in the case of eurodollars, allows for the tapping of huge pools of capital, which can be freed up for financing.
Why Should I Care?
Good question, always worth asking. Otherwise you risk landing up being an intellectual – great at cocktail parties, full of smart things to say, but broke. After all, what good is information you can’t or don’t execute on?
Eurodollars provide us with what is THE best insight into global capital flows and credit demand. Problems in the eurodollar market are problems in the market. Heck, this IS the market.
The eurodollar financing market took a massive blow to the skull back in 2007, which makes sense given that so much collateral was wiped from the system (the topic of my next article on this).
What is both fascinating and scary at the same time is that despite all of the central bank QE programs collateral has failed to come back into the system. It’s as if the eurodollar market is suffering from concussion. We know this by looking at the eurodollar market which has never regained levels seen back in 2007.
What this tells us is that the offshore money market world is failing to produce collateral and this failure to produce collateral is reflected in the eurodollar funding markets. QE doesn’t address this problem as it is interest rate driven stimulus and this isn’t a cost of capital problem but a collateral problem. But more on this in part II.
This is deeply disturbing, and the actions taken by central banks have actually sucked high quality collateral from the system. And it is this collateral which has traditionally underpinned the wholesale funding markets, the largest of which is the eurodollar market.
Remember in 2008 when the Fed, in a blind panic, opened dollar swap lines, which they deployed in an unlimited fashion and which actually got to about $600 billion that year?
Well, what was happening was that even though the Fed had taken a chainsaw to the Fed funds rate and opened the credit spigot to full throttle, the international