Demystifying the Eurodollar System
a primer on the offshore dollar market
Ever since World War II concluded, a one-of-a-kind monetary paradigm has been expanding and strengthening deep in the shadows of global finance: the Eurodollar system. Decades after its inception, it’s still difficult to envision how this eccentric yet enormous market operates. That is, however, until today. In this subscriber explainer, we’ll provide a definitive overview of the Eurodollar system and its mechanics, while answering the much-pondered question: “What are Eurodollars, really?”.
The most common origin story of the Eurodollar is that, in the early post-war era, America’s adversaries needed a place to store dollars outside the U.S. banking system to avoid unexpected seizures. Another version is that around the same period, global financiers discovered a way to profit from regulatory arbitrage by lending U.S. dollars overseas. Both accounts are accurate, yet the Eurodollar could only emerge out of what Concoda calls America’s post-WWII “global security pact”.
Following World War II, the U.S. by default became the dominant global superpower. But rather than choosing to conquer the world, the Americans instead convinced almost every major power to partake in a global “de-arming”: unobstructed trade on an international scale, with the U.S. providing the armed personnel to subdue (almost all) major conflict. This not only facilitated the most prosperous period in human history but the rise of the first truly global geopolitical currency.
Under America’s security pact, the financial giants of the world swiftly took advantage. The major U.S. banks set up branches not just in the U.K. — which grew to become the epicenter of Eurodollar activity — but worldwide. Major foreign banks then set up operations within the U.S., primarily in New York. This, combined with a prolonged period of heightened peace, not only gave rise to the most stable reserve currency on record. Financial behemoths had created the global dollar funding complex, featuring over 25 different types of dollar-denominated instruments, from FX swaps to reverse repos to commercial paper.
The global dollar funding complex helped spin intricate webs that provided dollars to anyone within America’s global security pact, but especially to those outside America’s borders. Introducing: the Eurodollar system.
The arbitrage above is one of many varieties of trades occurring in Eurodollar markets daily and reveals what “Eurodollars” have grown to become in the modern era of banking. But what exactly is occurring here? Let’s investigate.