In Some Ways, It Has Always Been Forward

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Includes: DRR, ERO, EUFX, EUO, FXE, UDN, ULE, URR, USDU, UUP
by: Alhambra Investment Partners

By Jeffrey P. Snider

There is certainly not enough attention paid to the evolution of eurodollars and even less devoted to how it all started. In my analysis, those two facets are inseparable as the origins of the eurodollar space tell us a lot about how and why it became what it is. The Japanese, for instance, were being squeezed by really unrelated funding pressures in 1963 that began in Italy, worked through Switzerland and ended up with the Japanese government actually selling US Treasuries to fund what was among the first problems with the "dollar short." In many ways, things have never changed even if the format has and complexities greatly proliferated.

According to some theories, the start of the eurodollar (or a strand of it) can be traced back to one British outfit - Midland Bank. The context was the mid 1950s and it has to be understood the systemic nature of the sterling at that moment in history. For several reasons, British monetary policy was exceedingly "tight" and not just in the normal central bank interest rate scheme.

The Chancellor of the Exchequer in 1957 even went so far as to prohibit the pound from financing trade between parties unrelated at all to the British currency - the very essence of what a reserve currency is supposed to do. In other words, with the sterling already in crisis, UK authorities banned foreign counterparties from using the pound to facilitate exchange between two (or more) non-sterling currencies. Unless the ultimate transaction was settled in pounds at the start or at the end, banks were supposed to turn away the business.

That opened the door for some other medium of exchange that could be both very flexible and less susceptible to such interference, and given that there was only one other candidate (gold being increasingly disfavored in this context despite the lip service of Bretton Woods) it was only a matter of time before dollars would fill the gap. US monetary and government officials, however, were not particularly enthusiastic over the possibility as it would mean further pressure on the US current account - dollars would have to flow overseas in order to build up enough "gravity" to act as a fluid global agent of exchange. That was already the case in certain money centers where US dollar trade had already been taken up, but even as late as the 1950s, there was still an enormous proportion of global geography conducting trade in sterling that would need transition.

Though the Federal Reserve had declared its "independence" from the Treasury in 1951, US interest rates were still far closer to their Depression conditions than a more natural assumption. That wasn't the case in much of the rest of the world, including the UK. Relatedly, Regulation Q had kept bank rates here low, too, while British government bills would often yield more than twice or three times the Regulation Q ceiling.

Since in the co-reserve era the sterling was convertible directly to dollars, there was a great deal of foreign exchange cover should that gap ever successfully get bridged. In other words, without exchange risk, UK government bills were on par in terms of risk as US government securities or bank deposits, leaving a huge arbitrage spread should anyone find the means to take it. Enter Midland Bank.

In February 1955, the Bank of England pushed its Bank Rate offer to 4.5%; a postwar high. Clearing banks had usually offered deposit rates at the Bank Rate minus 200 bps, leaving at that point quite the gap with UK T-bills that followed the Bank Rate. As you would expect, money flowed out of UK clearing banks and into UK T-bills leaving a large liquidity deficit that could not be answered by domestic means. Midland Bank, however, began offering a significant premium on dollar deposits (7/8ths of a %) above the ceiling of what Regulation Q allowed for domestic US banks (1%). Midland did not have an extensive foreign network and thus relied on its global correspondent relationships to find them.

The "magic" of the eurodollar was in the forward cover, namely that Midland sold new dollar deposits in the spot market for sterling, placed those sterling balances in either starving UK clearing banks at the Bank Rate or in UK T-bills whose maturity matched the final leg of the transaction - selling forward sterling to transition back to dollars at the end of the deposit. Since there was no exchange risk, the forward premium to buy dollars in the future was an additional spread that reflected only the full cost of "borrowing dollars." Because of the disparity in government demanded interest rates US to UK, Midland Bank could pocket a spread even when paying a large premium for the dollars and then another in the forward redelivery. It wasn't exactly a cross currency basis swap, but it was close and in many ways pioneered the same principles.

What made it work was the depth of swaps. There was an existing and rather deep market for dollar swaps that long predated this eurodollar-type activity, a market that largely owed itself to central banks working around the gold exchange standard (that is one of the major lessons from actually reviewing what central banks were doing in the 1940s, 1950s and 1960s; they spent an inordinate amount of effort and resources trying to avoid gold, meaning that the gold "standard" wasn't really that close to one for very long). The irony is tremendous, not just in how eurodollars turned out in the 1960s but especially in light of more recent events.

The forward premium on the dollar swap really dictated the success of the methodology, as it combined not just interest rate differentials but really the offered supply of what were now "dollars" in that context. If these now eurodollars were relatively "tight" because of idiosyncratic (largely central bank) factors, that would raise the forward premium enough to redirect "dollar" flow forward instead of taking advantage of interest rate spreads in the initial legs. That then led to upward pressure on those interest rates (initially UK T-bills but by the end of the 1950s, there were a number of other options for sterling investment because of British capital controls, including short-term borrowings of the Public Works Loan Board and Local Authorities financing) which conformed largely back to the forward dollar spread.

In short, the "supply of dollars" became the regulating agent for the whole thing, which as it was in the growth direction most of the time meant tremendous potential and tremendous stability (demand was far more variable). Throughout the 1950s and right through the 1960s that was the governing dynamic - no matter what and whatever central banks tried, London banks (largely) could "outbid" domestic US banks for deposits. In fact, the very idea of "London banks" might have at first been UK banks like Midland, but it wasn't before too long that this eurodollar swap was proportionally overseas branches of US banks (and Japanese).

It was natural convenience once Midland showed it could work, that UK authorities would look the other way (what Midland was doing was not in technical violation of monetary regulations or laws, but it stretched the limits which was precisely the point from their perspective) and the profit potential in the global intermediation via dollars rather than sterling. US banks could switch "deposits" from their home offices in NYC to eurodollar deposits in their London subs (or by 1969 in their Nassau shells) without ever having their customer leave the bank or really even the physical premises. To US/UK current account accounting it appeared like outflow/inflow, but in reality it was just dollar extension from domestic to global.

The more dollars attracted to the space, the more the dollar could overtake the sterling for more than just investment disparities among close financial substitutes. With a robust forward market, merchant banks could begin to offer very competitive trade financing terms in dollars that never had anything to do with actual, physical dollars - they were instead governed by a supply of essentially IOUs that had long ago lost any connection to physical deposits. In global trade, that was perfectly fine since companies in India, for instance, had no actual need of dollars except to convert into and out of another currency that wouldn't otherwise convert. The supply of eurodollars was eurodollar forwards, just chained liabilities that could easily balance so long as there was no determined interruption in the trading. Until August 2007, there never was.

This was the birth of the credit-based reserve currency, and it had started supplanting Bretton Woods maybe a decade and a half before Nixon in 1971. Some things never change, as though there are far more complexities and a much greater esoteric nature now (as difficult as it is to conceptualize the eurodollar even in the late 1950s) at its heart were and remain swaps and that as the basis for "supply." Take out the systemic proclivity for forward delivery of "dollars" no matter the ultimate format and the "dollar" falls apart; its Achilles heel. It was that way at the beginning and it is proving the same closer to what I think is the end.