Lesson 2 of 11
Due to the huge expansion in international trade from the early 1970’s, there was a huge growth in demand for foreign currencies to settle trade transactions. The availability of currencies for trading, and so the development of the FX markets itself, was facilitated by the development of the Eurodollar/Eurocurrency market.
Eurocurrency is money deposited with a bank outside the currency’s country of origin. The Eurocurrency markets or Euromarkets are markets for borrowing and lending currencies outside their countries of origin.
A Eurodollar, for example, is created when the owner of a US dollar deposit with a bank in the US transfers the money to an account with a bank outside the US. These deposits are lent to other customers by the bank, creating Eurodollar market activity.
A Eurocurrency deposit has the essential characteristic that the bank receiving the deposit must be resident outside the country of origin of the currency. For example, US dollars deposited with a bank in London are Eurodollars, regardless of whether the depositor resides inside or outside the US.
An organsisation wishing to borrow Yen, for example could borrow on the Japanese domestic money market from a Japanese bank, or in the Eurocurrency market, for example, by borrowing euro yens from a bank in Paris.
Until the late 1950s, US dollars deposited with banks outside the US were quickly repatriated because the banks taking the deposits invested the money in the US money markets. From the late 1950’s however as the dollar superseded sterling as the main international trading currency, the demand for US dollars by non-US residents increased. Dollars deposited in Europe were increasingly lent to borrowers in Europe, and the Eurodollar market grew. The supply of Eurodollars was increased by the US balance of trade deficit in the late 1950’s and early 1960’s , which created a flow of dollars into the hands of non-US residents.
The Euromarkets were further boosted in the 1960’s and 1970’s by domestic banking restrictions, particularly in the US, resulting in:
Increasing demand for Eurodollars from the European subsidiaries of US corporations, which were unable to borrow dollars in the US.
Higher interest rates on Eurodollars than the domestic dollar deposits. US banks used their European branches to move dollars into the euro market, thereby circumventing restrictive US domestic banking regulations.
Although restrictive regulations in the US were eased in the early 1970’s the Eurodollar market was sufficiently well established by then to survive and compete with the domestic US markets. In the 1970’s the Eurodollar market played a key role in recycling the petro dollars of oil-producing countries. Large dollar loans were made to countries suffering a balance of payments deficit as a consequence of the large increase in oil prices at that time.
Although the Euromarkets originated with the Eurodollar, and the Eurodollar remains the most heavily–traded currency, there are markets for other Eurocurrencies (euro deutschemarks, euroyen etc.)
The Euromarkets are for borrowing and lending currencies, whereas the FX markets are for buying and selling them. However, there is a very close connection between the two markets.
The difference between spot rates of exchange and forward rates of exchange in the FX markets are accounted for by the interest rate differentials between the currencies in the Euromarkets.
There is little difference between a Eurocurrency loan and a forward swap in the FX markets. A forward swap is an agreement to buy one currency in exchange for a second currency and a simultaneous agreement to sell back the currency at a future date, but at a different rate of exchange. The difference between the exchange rate for the initial purchase and subsequent sellback is accounted for by the interest rate differential between the Eurocurrencies.