Among the earliest participants in the eurodollar system were Canadians. Though these dollars were floating around Europe, primarily, Canadian banks stood ready to borrow in bulk as needed. Not for their own purposes, the trade contributions therefore financing needs of firms within the country were relatively small. Instead, our friendly banker neighbors to the north were gracious enough to relend to American securities firms in New York money markets.
Before it was even called the eurodollar it had been named the Continental dollar centered around the cities of London and Paris. The former made perfect sense because of its position within the British Empire – the mercantile empire where capital from throughout the world might flow in and out of its capital.
The capital of France emerged as a key recipient of American money in one form or another. And it was there where the Canadians did so much of their business, at least the first half.
As they did so, that business brought them into competition with other uses for this intranational currency. While it might at first seem weird that US brokers would need this external supply of, well, US dollars from Europe via Canada, the Great Depression and its regulations still loomed large over all within the United States.
Much of what the Continental dollar did up to that early time, the late fifties, was finance trade throughout the Continent. Exigencies from World War II still loomed large over much over there. Thus, it became easier to do business on dollar terms “offshore” than in many local currencies and jurisdictions.
European money markets had previously developed a high degree of sophistication which they brought with them into this new brand of circulation. Among these, swaps and forward markets meaning time value. We might think of these as “modern” inventions far more at home in the eighties or nineties, both were crucial to development of eurodollars in the fifties.
Intermediating banks, including Canadian, would take in deposits of all number of European (or Asian, such as yen) currencies then immediately swap them into dollars; not actual dollars, no physical stacks of US currency, rather creating a book entry when that foreign currency was put up as collateral borrowing dollars from a supplier who made the same yet opposing entry on its books (to the dollar borrower, the one who just made the swap, it was an unconditional liability; to the provider, a claim or loan asset).
To minimize any exchange risk, the dollar borrower might then sell forward the same dollars timed to match the duration for when the original currency swap would unwind. Firms from all around Europe then the rest of the world (expanding first with Japan) could intermediate fluidly through what truly was a reserve system (outside the boundaries of Bretton Woods, too).
Here's an example written up from early observations made on behalf of FRBNY way back in November 1960 (when it was still referred to as the Continental dollar, the term eurodollar having first emerged only a short time earlier):
“For instance, an Italian bank might have a customer who wished to borrow sterling to finance an import from the United Kingdom. The bank might then take advantage of the facilities of the Continental dollar market to arrange to receive a deposit, say, from a British bank, of a corresponding amount of dollars. It would then seek out an opportunity to reduce its borrowing costs by making a profitable swap—i.e., if the forward dollar were at a discount against the guilder, it would sell spot dollars, say, to a Swiss bank, and buy them back (at a lesser cost in guilders) forward. It would then lend guilders to the customer and in turn, for the customer’s account and risk, convert the guilders into sterling.”
Nothing primitive about late fifties dollar trade. Again, though, the importance of the forward market in it meant it was vital for the money dealers, often both suppliers of these “dollars” as well as, at times, borrowers, to remain fully engaged.
One potential drawback is that forward time. Not all transactions can be immediately matched to the corresponding unwinding future leg. Banks providing (selling) dollars might look ahead with a touch less optimism. Suddenly, “forward dollars” become expensive, maybe unmanageable.
If in the example above the Italian bank had already taken the deposit from its counterpart in the UK and had sold spot dollars to the Swiss, but had not yet arranged the forward dollar buyback, it was functionally “short” the dollar on unconditional terms, an obligation to return the dollars to the UK bank at the known maturity.
Should the forward price of dollars suddenly change from discount to large premium, losses can pile up too quickly.
Thus, the true binding condition for banks not just in this one situation rather the entirety of the system comes about from thinking ahead for what dollar providers might charge for future dollars that aren’t actual dollars to begin with. And that depends upon a variety of factors derived from perceptions about conditions down the road.
Now think about the same in the context of our Canadian friends who have relent these Continental dollars into New York money markets to faceless borrowers who tended to be riskier securities brokers rather than insured depositories on behalf of renowned mercantile companies. I don’t want to make too much of those risks as they were in the late fifties or even into the sixties beyond, but at some point there might come a time when it could finally happen in reality.
This was August 9, 2007, of course.
In FRBNY’s example, the goal had been to finance some real economy trade, an import into Italy from the UK. What the Canadians and then so many others were doing was more speculative, redistributing these foreign “dollars” back into the US to finance some real economy credit though quite often whatever “hot” securities any broker might want to float.
Eurodollar intermediaries would thus have to consider potential issues across all ranges of financial and trade behaviors. And it would mean that perceptions over purely financial factors, such as maybe New York brokers becoming “too” haphazard causing some second looks at their Canadian eurodollar providers which might get them charged higher and higher premiums on forward dollar requirements.
The potential systemic knock-on effect is when forward premiums arise not just for Canada, but also for the Italian bank seeking to import real goods from whatever company in Britain.
Under normal conditions, these risks remained quite small and manageable no matter what had happened. The first real test came in 1997 during what wasn’t an Asian Financial Crisis but instead too much premium being asked of forward money in dollars for financial as well as trade uses across too much of Asia.
As it turned out, the math used by dollar providers to map out risks over providing dollars in the future, the swappers and forward sellers, had been highly flawed and didn’t encompass the full range of real world possibilities (the inherent flaw in all statistics). Provoked by such surprise, they abandoned dealer functions leaving those with unconditional obligations few workable alternatives.
While I write it up in this way, making it seem like once the risk aversion “switch” is flipped, it’s like day turns to night; friendly forward dollar discounts offered yesterday abruptly transform into ugly, unaffordable premiums today. The whole thing is a complicated process, as you might imagine just from trying to untangle the various incentives and structures embedded within that six decade-old hypothetical quoted above.
Imagine what more it might have featured in ’97 or by ’07.
In that sense, complication is both foe and friend, to an extent. Something goes wrong, forward premiums materialize, but under the veil of complexity any damage remains minimal as hardly anyone can uncover the source or the true degree of distraction. A small bump in the otherwise forward-looking road.
This kind of information asymmetry, though, as we’d come face to face with fifteen years ago, can work against it. Risk aversion from overextended financial counterparties becomes forward dollar premiums that then interfere with real trade and economy functions. A market hiccup transformed into an actual real-world disruption since the real downside in this comprehensive monetary system is having everything tied to it and in ways not easily determined from the outside (or even inside).
The reason trade sectors suffer first and more than others isn’t just the high degree of dependence on what is a reserve currency, it has how globalized trade itself long ago became very money intensive. This was highlighted in a recent paper published at the BIS (Theory of supply chains: a working capital approach; h/t Mr. Emil Kalinowski) which stated:
“One consequence of this feature is that long production chains and offshoring are sustainable only when credit is cheap, and chains that have become over-extended are vulnerable to financial shocks that raise the cost of borrowing. Our model has been deliberately stark so as to highlight the role of working capital.”
From the very start, the authors realize, “To the extent that the financing cost of working capital matters, the length of supply chains is not only a matter of the economic fundamentals (such as the production technology or trade barriers) but is also shaped by financial conditions.” Can’t import goods if forward “dollar” premiums get too high.
They don’t use that language, of course, instead relying on the typical and frequent habit of purposely substituting the term “financial” when the problem is pure monetary. Financial factors become those forward premiums raising the cost of international money in a way that no central bank can fix or truly do much about (apart from selling and using reserve assets, never to any avail).
It is this latter fact, one realized and appreciated from the very beginning by those inside the system, which is to be covered up intentionally under this word “financial” so as to avoid arousing public suspicion over what are entirely monetary setbacks. The Federal Reserve, most of all, is allegedly the primary US dollar monetary agency.
Instead, Canadian banks back at the end of the fifties had more to do with it than Jay Powell does sixty years later.
Any rational accounting for risk must also incorporate this fact. In fact, starting from it, the condition for dollar providers and swappers to flip from risk-taking to aversion may not be all that severe.
For that reason, any serious enough monetary (not financial) disruption becomes a serious economic drag only through time. Again, it is not like flipping a switch, a complicated and drawn-out process of incorporating new information and prices, then responses to them. We might witness the clear symptoms of money disorder - such as the rising US$ exchange value or the premium paid on collateral - without seeing an immediate impact upon real economy statistics.
The great monetary disruption observed first on August 9, 2007, for example, wouldn’t make its full destruction known until the following summer when the US economy finally showed the unmistakable signs of severe recession (and that wasn’t from disruption in trade, rather more direct credit available domestically).
Last year we saw major upset in this very global money, though it hasn’t exactly shown up in global economy. But we do know dollar providers are biding their time and betting heavily on it.
