This document discusses the Eurocurrency market. It defines the Eurocurrency market as a market where international credit, deposits, and loans are exchanged in currencies other than the domestic currency of the country where transactions occur. Some key points made in the document include that the Eurodollar market makes up over half of Eurocurrency activity, Eurobanks can offer narrower interest rate spreads than domestic banks due to lower costs and less regulation, and the net size of the Eurocurrency market measures the amount of credit extended to non-bank entities excluding interbank transactions.
2. Outline of the Chapter
What is Eurocurrency market?
Reasons for offshore banking
Interest rate spreads and risk
LIBOR
International banking facilities
Offshore banking practices
3. What is Eurocurrency Market?
Eurocurrency market – a market in which
international credit, deposits, and loans are
exchanged, in a currency other than the
domestic currency.
Eurobanks – banks that accepts these
deposits and make loans.
◦ Example: Citibank in Aruba that accepts dollar
deposits and make loans in dollars is referred to as
a eurobank.
Note that the prefix “Euro” is just a historical
nature. The eurocurrency market was initially
started in Europe.
◦ European banks wanted to lend and deposit in U.S.
dollars.
4. Eurocurrency
Funds deposited in a bank when those
funds are denominated in a currency
differing from the bank's own domestic
currency.
Thus, if a Japanese company deposits
yen in a Canadian bank, the yen will be
considered Eurocurrency
Example:
◦ Eurodollar = dollar bank accounts outside the
U.S.
◦ Euroyen = yen bank accounts outside Japan.
◦ Euroeuro = euro bank account outside the
Eurozone.
5. History of Eurocurrency Market
Market originated in the 1950s, when communist
governments (mainly the Soviet Union) needed dollars for
international trade and concerned about a potential freeze
of their dollar accounts in US banks, shifted their deposits
to London.
Due to political tension and economic boundaries, many
people around the globe were looking for ways to avoid
regulatory costs and restrictions set by the government.
In the 1960s and 1970s, US banks established offshore
branches to escape US regulations and to make
eurocurrency loans.
Specifically, these restrictions involved: special charges
and taxes on domestic banking; requirements to lend
money to certain borrowers at concessionary rates;
interest rate ceilings; rules that prevented competition
among banks; and reserve requirements.
6. The currency composition of
the Eurocurrency market
(2010)
Eurodollar
58%
Euroeuro
21%
Euroyen
3%
Europound
5%
Others
13%
Source: Bank of International Settlements
7. The major offshore financial
center
Offshore Financial Center – countries that contain financial
institutions that deal primarily with nonresidents and/or in
foreign currency.
The host country usually grants complete freedom from host-
country governmental banking regulations.
They are usually characterized by a low (or zero) tax
environment and specializing in providing corporate and
commercial services to non-resident entities on a confidential
basis.
Example:
The Bahamas
Bahrain
Bermuda
The Cayman Islands
Mauritius
Hong Kong
The Netherlands Antilles
Panama
Singapore
Switzerland
8. Reasons for Offshore Banking
To avoid high costs of banking from domestic
regulations.
◦ Ex: U.S. banks are required to hold required
reserves, while the Eurobanks are unregulated and
can hold much smaller reserves than their U.S.
counterparts. The U.S. banks outside the U.S. can
offer higher interest on deposits and lower interest
on loans.
This does not mean that the countries hosting
the Eurobanks do not have regulations.
◦ They do.
However, they have two sets of banking rules.
◦ More strict rules on banking in the domestic
currency, whereas banking in foreign currencies
are unregulated.
9. Definition: Spread
Spread – the difference
between the deposit and
loan interest rates.
The Eurobanks can offer
narrower spread than
their counterparts.
Ex. Citibank in Aruba
can offer narrower
interest rate spread on
dollar banking than
Citibank in New York.
◦ Lower rate on dollar loan
than the NY branch.
◦ Higher rate on dollar
deposits than the NY
branch.
11. Reasons for narrower spread
Without these differences, Citibank in Aruba would
not exist.
Your dollar deposits in Aruba is considered riskier
than dollar deposits in NY, because the Aruba
branch does not have Federal deposit insurance
and government supervision. Thus, to attract
people to deposit at the Aruba branch, Citibank has
to offer higher deposit rate than in the U.S. branch.
In terms of interest rate on loans, if Citibank in
Aruba offers identical interest rate on a loan as in
the NY branch, you would be less likely to take out
a loan from the Aruba branch.
To attract borrowers, Citibank in Aruba will have to
offer lower interest rate on a loan than in the NY
branch.
12. More Reasons for Offshore
Banking
To avoid interest rate controls and
government-mandated credit allocations.
To avoid capital controls, such as quotas
on foreign lending and deposits, and taxes
on capital flows.
To avoid a threat to private property right
(Ex: if the government threatens to
confiscate foreign deposits).
To access more competitive banking.
There is no restriction on entry of new
banks in the external markets.
13. LIBOR
LIBOR = London Interbank Offered Rate
LIBOR = interest rate that a group of large
London banks can borrow from each other
each morning.
LIBOR is the most important interest rate in the
world.
◦ Loans if $10 trillion and swaps contracts of $350 trillion
around the world are directly tied to the LIBOR.
◦ Half of the U.S. adjustable mortgage rates are tied to
LIBOR.
LIBOR is important because it is used by banks to
scale loan rates (i.e., as a benchmark rate) to
clients.
14. How is LIBOR set?
Each morning a panel of banks submit their
LIBOR data to the British Bankers’
Association (BBA).
BBA averages that data and sets a value of
LIBOR each day at 11 a.m. of London time for
each major currency.
◦ 10 currencies
◦ 15 maturities: overnight to 12 months.
Recently, there has been some questions
about whether banks have tried to fix the
LIBOR.
Since the number of participants are small,
banks may have colluded in setting the LIBOR.
15. Example: LIBOR on April 3, 2012
Euro, US dollar, and Japanese yen
The US Dollar
LIBOR
interest rate is
the average
interbank
interest rate at
which a
number of
banks on the
London money
market are
prepared to
lend to one
another in US
Dollars.
Maturity Euro LIBOR USD LIBOR JPY LIBOR
overnight 0.25929 % 0.15100 % 0.10586 %
1 week 0.28143 % 0.19020 % 0.11643 %
2 weeks 0.29371 % 0.21250 % 0.12371 %
1 month 0.36186 % 0.24125 % 0.14429 %
2 months 0.48543 % 0.34980 % 0.15857 %
3 months 0.67450 % 0.46915 % 0.19571 %
4 months 0.79436 % 0.56785 % 0.23929 %
5 months 0.89079 % 0.64940 % 0.29371 %
6 months 1.00836 % 0.73440 % 0.33586 %
7 months 1.08036 % 0.79300 % 0.38586 %
8 months 1.14050 % 0.84020 % 0.43229 %
9 months 1.19364 % 0.88680 % 0.47443 %
10 months 1.24914 % 0.94040 % 0.50300 %
11 months 1.30729 % 0.99370 % 1.32821 %
12 months 1.37029 % 1.04970 % 1.38564 %
16. Offshore Banking Practice:
How to measure the net size of the
Eurocurrency market?
Measuring the actual size of the Eurocurrency market can
be difficult because a distinction needs to be made
between the gross and net size of the Eurocurrency
market.
◦ The gross measure includes both non-Eurobank and
interbank deposits.
◦ The net measure excludes interbank deposits.
The gross measure gives an idea about the overall activity
in the Euromarkets, while the net measure gives a better
indication concerning the ability of the Eurobanking
system to create credit.
If we only look at the total activities in the market, we
would overstate the actual amount of activities.
The net size of the Eurocurrency market activity = the
total deposits (or total loans) minus the interbank
activity.
17. Example: Gross vs. net volume of
Eurodollar activity
Suppose that IBM (American firm) in New
York shifts $1 million from its U.S. bank to
a Eurobank A (in Aruba) to get higher
deposit rate.
18. Now suppose that Eurobank A deposits the $1
million with Eurobank B (in Bermuda).
Example: Gross vs. net volume of
Eurodollar activity
19. Finally, suppose that Eurobank B makes a $1 million
loan to BMW in Germany.
Example: Gross vs. net volume of
Eurodollar activity
20. The total deposits in
Eurobank =$2 million ($1
million from Eurobank A
and $1 million from
Eurobank B).
The net deposits =
$2 million - $1 million
(from interbank deposit
between Eurobank A and
Eurobank B) = $1
million.
This $1 million is the
value of credit actually
intermediated to
nonbank borrowers.
Example: Gross vs. net volume of Eurodollar
activity
21. International Banking Facilities
(IBFs)
In 1981, the Federal Reserve allowed U.S.
banks to engage in a special type of
Eurobanking activity on the U.S. soil.
International banking facilities (IBFs) allow
depository institutions in the United States to
offer services to foreign residents and
institutions free of some Federal Reserve
requirements and some state and local income
taxes.
IBFs enable U.S. institutions to compete more
effectively for foreign-source deposits and loan
business.
Banks may conduct their IBF activities in their
existing quarters, but they must maintain
separate IBF books.
22. Summary
The Eurocurrency market is a banking market where commercial banks
accept deposits and extend loans in a currency other than the domestic
currency.
The Eurodollar, the U.S. dollar-denominated deposits and loans outside
the U.S., has the highest volume of activity among other currency
offshore banking.
Compared to domestic banks, the Eurobanks have lower operating
costs and are not regulated. Therefore, they are able to offer narrower
spread than domestic banks.
The Eurocurrency market improves efficiency of international financial
market. Efficiency comes from access to low-cost borrowing, lack of
government regulations, and strong competition among the Eurobanks.
LIBOR is an important interest rate that is used as a benchmark
interest rate to set loan rates.
International banking facilities (IBFs) are divisions in U.S. banks that
are permitted to engage in Eurocurrency type banking in dollars with
foreign residents.
The net size of the Eurodollar market measures the amount of credit
actually extended to nonbanks.