Eurocurrency
The term ‘Eurocurrencies’ refers to domestic currencies of one country on deposit in a bank in a country other than the country issuing the currency (Eiteman, Stonehill and Moffett, 2015). Any currency that can be easily and freely exchanged for a foreign currency, what known as convertible currency, can exist in ‘Euro-’ form. For example, a U.S. dollar-denominated deposit in a bank in London is called a Eurodollar. A yen-denominated deposit in a bank in New York is called a Euroyen. A sterling-denominated deposit in a bank in Toyko is called a Eurosterling. A euro-denominated deposit in a bank in Sydney is called a Euroeuro. Note that the prefix ‘euro’ in the Eurocurrencies does not mean the European currency, the euro (€)!
Eurocurrency businesses are mostly conducted by a department of a large commercial bank, which usually has worldwide operation. Banks in which Eurocurrencies are deposited are called ‘Eurobanks’. These banks perform the role of financial intermediaries. They accept deposits and make loans in a currency other than that of the currency of the country in which they are located. The ‘Eurocurrency market’ is an international money market where short-term funds flow across borders. Unlike the domestic financial markets, the Eurocurrency market operates without government regulations (e.g., reserve requirements, deposit insurance, or rules and regulations that restrict competition among banks) and interference.
The Eurocurrency market is one of the most significant innovations in international finance in the postwar period. The market is largely dominated by the Eurodollar transactions (i.e., the U.S. dollar-denominated deposits/loans outside the United States). The ‘Eurodollar market’ emerged shortly in the aftermath of World War II and had developed greatly as the result of political tension during the Cold War period. Prior to the 1960s, the amount of U.S. dollar deposits outside the U.S. territory was trivial. In the period of Cold War, governments of communist countries feared that their U.S. dollar deposits in the United States would be confiscated. Eastern European holders of U.S. dollars and the state banks of the Soviet Union deposited their dollars with banks in London and Paris instead. A large amount of petro-dollars flowed to the Eurodollar market during the period of Oil Shocks in the 1970s as members of OPEC (Organization of the Petroleum Exporting Countries) preferred to deposit their dollar balances outside the United States. The Eurocurrency market has expanded to include other important currencies such as the Japanese yen, the British pound sterling and the euro.
The increasing openness of national financial markets has accelerated the development of the Eurocurrency market. The Eurocurrency deposit has become an efficient and convenient money market instrument for short-term investment and the Eurocurrency loan has become an important means for short-term financing. Owing to the absence of government regulations, interest rates paid on Eurocurrency deposits are typically higher than those in the domestic financial market while interest rates on Eurocurrency loans are usually lower than those in the domestic market. Many institutions utilize the Eurocurrency market. The market has become an important channel of short-term investment and financing for commercial banks, multinational corporations, and institutional investors.
Central banks of many countries keep part of their reserves in the form of Eurocurrency deposits as these deposits earn a relatively higher yield. Commercial banks tap funds from the Eurocurrency market, especially when the government of their home country tightens banking regulations. Institutional investors manage their liquid funds through the financing and investing activities in the Eurocurrency market. Multinational companies find financial advantages to keep their foreign currency balances in the Eurocurrency market. More specifically, the Eurocurrency market serves multinational corporations in two important ways. First, the Eurocurrency market is a short-term investment market for global companies, allowing the companies to earn a relatively high return on their excess funds. The Eurocurrency deposits can be tailored to the needs of individual clients with the maturities ranging from overnight to 12 months. Second, the Eurocurrency market is an important market for global firms to borrow short-term to finance the firms’ working capital needs.
Let’s have a closer look at how the Eurocurrency is created. Suppose that a Japanese firm sells equipment to a buyer in the United States and receives a US$1 million check drawn on a Citibank in New York. Next month, the company will use this amount of money for financing working capital of its U.S.-based operation. To earn some return from the idle funds, the Japanese firm can invest the money in the U.S. money market. The firm can get a higher return if it places the idle funds in a U.S. dollar-denominated time deposit with a bank in London. By depositing one million dollars with a bank in London, the Eurodollar deposit is created. The dollar account held with Citibank in New York is substituted by a dollar account in a London bank. The ownership of the 1 million US dollar deposit is transferred from the Japanese firm to the bank in London. The bank in London can then lend this Eurodollar funds to non-bank borrowers (e.g., government or corporation) or to other commercial banks, or place the funds in the London Interbank Market.
Due to the liquid nature of the market, the size of the Eurocurrency market is difficult to determine. The volume of the Eurocurrency market changes every day as the liquid funds are transferred across the globe. The Eurocurrency trades are mostly overnight, although Eurocurrency deposits and Eurocurrency loans can have maturities up to 12 months. Transactions in the Eurocurrency market are in large denominations, for a minimum of million US dollars and a maximum of billion US dollars in a single transaction. So far, the Eurodollar has been the biggest Eurocurrency market with most of the Eurodollar trades taking place in New York.
References
- Eiteman, D.K., Stonehill, A.I., and Moffett, M.H. 2015. Multinational Business Finance. 14th edition. New York: Pearson Addison Wesley.
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