Understanding Global Liquidity, Part 2: Eurodollars
Understanding Global Liquidity, Part 1: Credit Condition Matrix described a framework for understanding today’s global economy through the the interplay between credit demand, credit supply and interest rates.
Part 2 is focused on describing the Eurodollar system. The more I’ve learned about Eurodollars, the more I’m shocked to find out how critical this system is to the global economy, especially given how little people discuss it.
Almost all of what I’m about to discuss has been taken from Jeffrey P. Snider’s blog posts and interviews on the Macro Voices podcasts. Those resources go in to far more detail and provide valuable context compared to this brief discussion. My focus will be, again, describing the mechanics in simple terms to help newbies like myself get their footing. You should really hear it from the horse’s mouth to understand the details.
(Also, I may have some of the details wrong, as I’m working second-hand and still just learning it. I’ve never been a banker—you’ve been warned).
Dollar. Dollar? Dollar!
One of the first revelations I had in my quest to understand global liquidity is that—though everyone says the US Dollar is the world’s reserve currency—that’s not true.
People get confused because the naming conventions are total crap. There are actually three types of “dollars” in existence:
- US Dollars
- US Bank Credit Dollars
The US Dollar is a currency that is printed by the Federal Reserve, used to buy US assets, and multiplied into credit-money (US Bank Credit Dollars) by US banks via the fractional reserve banking system (the US Banking System).
Eurodollars are “dollars” created by foreign banks via an entirely different fractional reserve banking system (the Eurodollar Banking System). This started in Europe, but a Eurodollar can be anywhere outside the US: Asia, Latin America, Australia, etc.
At first, this was almost the same thing as what happens in the US Banking System. Today, it’s very much not.
Origins of the Eurodollar System
The Eurodollar system started in the 1960’s, when foreign banks found themselves holding large deposits of US Dollars. These deposits arose out of the fact that the US bought a whole lot of stuff, paid for in US Dollars. US Dollars started circulating outside the US.
Foreign banks started making loans against those deposits, creating the first Eurodollars. We think of “dollars” as the world’s global reserve currency. By virtue of the fact that foreign institutions have to work with foreign banks—and that there’s so much more credit-money than deposits—it’s actually the dollar-denominated credit-money created by foreign banks (Eurodollars) that serves as the world’s reserve currency. Since these banks are outside the US the Fed doesn’t regulate them. Since they’re working with non-local currencies, their central banks don’t regulate this activity either.
The demand for the world’s global reserve currency is being met by foreign banks through their own, unregulated, fractional reserve banking system.
So, far so good. If you understand fractional reserve banking, you probably understand the above without too much difficulty.
A Little Bit Deeper into the Fractional Reserve Banking System
To get a deeper understanding of Eurodollars, we’ll have to dive deeper into fractional reserve banking systems. It’s always been one of those “hard to wrap my head around” concepts for me, so forgive me if I’m belaboring points some of you find basic.
Let’s say I’m the first US bank ever, and I receive $100M in deposits. As a bank, I can take that money and make $90M in loans, keeping 10% of the deposit as reserves.
By making the loans, I’ve effectively created $90M in “money”. The original depositor still has their $100M, and a bunch of borrowers have $90M that didn’t exist before. The people who receive those loans can spend the “money” just like the people who made the deposits. All $190M is available to become income to other people—who make their own deposits, which become the basis for more fractional reserve loans, etc. With a 10% reserve rate, the original $100M in real currency deposits can support $1B in “money”.
Because I’m the first US bank ever, I know that the $100M deposit is new money into the banking system. As such, it consists only of US Dollars, printed by the Federal Reserve. In terms of the fraction reserve banking system, the $100M is collateral.
The $90M in loans that I make, as the first US bank ever, are made by creating a liability and an asset in my borrowers’ accounts. In terms of the fractional reserve banking system, these loans are credit (as are all of the $900M eventually created). By virtue of being in the banking system, all of the money becomes credit-money.
The fractional reserve system takes collateral and creates credit, with the maximum amount being Max Credit = Collateral / Reserve Rate.
There is no distinction between collateral or credit-money while the money is in the banking system. Depositing the money into the system converts it from collateral to credit-money, and withdrawing it converts it back. As soon as it’s given to the bank, the $100M deposit turns from $100M of US Dollars into $100M of US Bank Credit Dollars. All of the loans made are made in US Bank Credit Dollars. But it doesn’t matter that these dollars started out as US Bank Credit Dollars, they can be turned into a US Dollars by withdrawing from the system just the same.
This always bothered me. How is this possible? Why doesn’t the whole thing fall apart? There’s not really enough “money”, is there?
It keeps going because no one needs the physical currency to “spend” the “money”. “Spending money” means transferring it from one bank account to another. The collateral is nowhere and everywhere all at once, like an electron-cloud in an atom. It doesn’t matter exactly where the collateral is or who owns it. The critical factor is that—as long as the collateral stays inside the system—the system “has” the needed collateral and can use it to support the credit-money. Everything works just fine.
We’ll come back to this, but it’s important enough to repeat with an analogy: It’s like we’re filling a balloon. The balloon is the economy, and the size of the balloon is measured as GDP. We only have so much helium (collateral), and we’d like to make the balloon bigger than it otherwise would be. So we heat the balloon (creating credit-money). Each helium molecule moves much faster, now acting as if it were 10 molecules instead of just one. The balloon grows (GDP goes up). If the molecules ever slow down (credit is reduced), the balloon shrinks (GDP goes down). If the helium molecules ever start escaping the system, the balloon starts to collapse—and each molecule lost now causes 10x the damage it did before the heating process started.
Once you fill the balloon, the collateral has to stay in the system or bad things happen.
The Big Eurodollar Leap
Now for the crazy part.
In the fractional reserve banking system that is made up of US banks and depositors (the US Banking System), the collateral is US Dollars, which support credit-money (US Bank Credit Dollars). The US Banking System can support a total of $40T of total money, consisting of $36T of credit-money based on $4T in collateral. Because US Bank Credit Dollars are derived from US Dollars—and US Dollars are physical currency—we’ll call this a 1st derivative fractional reserve banking system.
The Eurodollar Banking System started out as another 1st derivative fractional reserve banking system, parallel to the US Banking System and based on the same collateral.
But Europe is really far from the US. When the US bought all that stuff from other countries (or when someone wanted to move their money from a US bank to a foreign bank to earn more interest), it was too much of a bother to actually ship physical US Dollars to other banks, all the way over there.
Instead, the banks just agreed to keep track of IOUs. If I’m Bank A in the United States, and you’re Bank B in London, I just say “I owe you $1M”. This doesn’t change much for me. When a client deposits money with me, I get cash (an asset)—and I owe them that cash, so I have a liability. By transferring the “money” to you (Bank B), I just owe you instead of my original client. This is just a regular credit-money loan to me. I still keep the cash. Let’s not worry about the physical realities of vaults, etc. The critical fact is that no collateral has left the US Banking System—the US Banking system can support the same amount of credit-money.
For you, as Bank B, things do look different. In accepting the transfer, you said, “Okay, you owe me $1M, and I owe my new client $1M”. Your assets and liabilities have both gone up by $1M. We’ve extended the original system with an interbank liability.
Also, to you—as Bank B—this transaction also looks awfully lot like you just got a new client deposit. What do banks do with the money that clients deposit with them? They loan against it. Why not do the same here?
This is the crazy.
You, Bank B, are making loans, using this “deposit” as collateral. But there was no US Dollar deposit. The original US Dollars are sitting in the US Banking System, supporting the credit-money there. The loans you’re making are against a “deposit” that is actually a liability owed to you by another bank. We now have a whole new form of credit-money (the modern Eurodollar), using the US Bank Credit Dollar (itself credit-money) as collateral.
The Eurodollar Banking System isn’t a parallel fractional reserve banking system anymore. Let’s take it step by step:
- $100M in US Dollars is deposited into a bank
- Banks make loans, multiplying that original $100M of collateral into $900M of US Banking Credit Dollars
- Some of that money (say $200M) gets transferred overseas and into the Eurodollar Banking System—but it’s only the US Banking Credit Dollars that move. The US Dollars remains as collateral in the US Banking System supporting the credit-money supply.
- Foreign banks start making loans, using that $200M of US Bank Credit Dollars as collateral, multiplying it into up to $1.8B of new credit-money (Eurodollars)
- The original $100M in US Dollars is now supporting $2.7B in credit-money—$900M in US Bank Credit Dollars and $1.8B of Eurodollars—as opposed to the $900M it was originally supposed to support
Eurodollars are the 2nd derivative of the US Dollar.
Any bank across the globe can create this credit-money. As stated before, no central bank regulates Eurodollars. These banks don’t report the transactions to any central authority—making the activity very difficult to measure. We don’t really know how many Eurodollars there are floating around out there.
One data point, provided by Jeffrey P. Snider in this post on “footnote” dollars, is that regulators recently found $15T of dollar-denominated debt outside the US that no one knew existed until just now. How big does a system have to be before you can fail to notice $15T of it?!
As a sizing exercise, if all US Bank Credit Dollars were shipped overseas, the $4T in US Dollar could support $400T in Eurodollar bank liabilities. If 20% of US Bank Credit was shipped overseas, the $4T in US Dollar would be supporting $80T in Eurodollars—this is in addition to simultaneously supporting the $40T in US Bank Credit Dollars!
Of course, this is just a sizing exercise…
All the World’s the Stage
The creation of an unregulated and untracked banking system that has the potential to be as least as large the official US Banking System seems egregiously irresponsible—but the Eurodollar Banking System grew out of an unmet, global demand for credit that started after WW2. These trades were profitable for decades because the rest of the world was busy growing like crazy and needed credit to do it. Somebody needed to provide the credit needed to build out the highly productive, global economy we have today.
The 2nd derivative nature of Eurodollars is what let the Eurodollar Banking System grow both large enough and fast enough to meet that need. The fact that it did grow so big makes it critical to global economic activity.
Back when the US was 40% of global GDP (and US companies were focused on meeting US-based economic demand), you could focus solely on the US Banking System. Now, when the US is 20% of global GDP (and much of that GDP comes from meeting international demand), trying to understand what’s happening anywhere (including in the US) absolutely requires understanding the Eurodollar system.
We’ve just described a huge, incredibly profitable business with no regulations and limited visibility. How long do you think it’d be before other people wanted in on the action?
Part 3 will explore how bond-traders started crowding in on the money-creation and lending game.
DISCLAIMER: None of this intended as investment advice. This is a place for me to put down my ideas and share them with others, whom I fully expect will tear these ideas apart. I have no professional training or certifications, and I've probably already changed my mind on whatever you just read.