Eurocurrency Market Dynamics - Example

Eurocurrency Market Dynamics Name College Course Tutor Date The development and continued existence of Eurocurrency market is attributed to different financial regulations in different countries coupled with reduced barriers to international trade. Eurocurrency market gave rise to other financial innovations among them is Eurobond, euroequity markets and euro-commercial paper. The dollar being the native currency of USA and pound for UK transactions involving this currencies could done from native country currencies. The precise definition of Eurocurrency has been marred with heated debate from varied scholars as Gowland (1979) acknowledges it. However, the overall perspective is the basic fact that a banking market active outside the jurisdiction, which issued the currency. Foreign currency deposits has grown tremendously in recent years. The Eurocurrency market plays a key role in terms of raising short-term finances for firms. The market base in 1960 was about 2 Billion dollars and by 1980 it was 1500 Billion dollars. The general assumption among scholars is that Eurocurrency market was founded around 1927 and it originated in Europe and its growth was catalyzed by the dollar shortage of 1957-8 which allowed for convertibility into European currencies as Smith (1982)) alludes. Some scholars however attribute the growth of Eurocurrency market to being born in mid 1950s when most Eastern European countries including the Soviet Union had reservations in holding their deposits in form of dollars for fear of being seized by US government to compensate for its citizens who suffered the losses occasioned by war. These countries resorted to depositing their dollars in London banks rather than US banks. The Eurocurrency market received a major boost when the British government directed her financial banks not to lend to non-British citizens using domestic currency in 1957. Therefore, London banks had to encourage Dollar deposits in order to lend out to international business and persons. From then London has remained to be leading financial hub for Eurocurrency. However, what further catapulted the flourishing Eurocurrency market was the stiff regulations in the American and British markets that increased the onshore cost of doing business. In Britain, for example, the Bank of England limited the use of pound to finance external loans and foreign trade. Also in US, the government set up ceilings on interest rate and this added an impetus for depositors to move funds offshore to higher rates of interest. With the rise of Eurocurrency, market in 1960s worldwide most governments enacted stringent regulations on residents trading on their own currencies but not on foreign investors trading on foreign currencies hence leaving the Eurocurrency market to flourish. The analysis of Gurley and Shaw's ( 1960) of regulated against unregulated financial intermediaries clearly demonstrated the disparity in performance of the two with the regulated market doing poorly while the unregulated market continued to grow. The graph below shows the trend of currencies and financial assets held by European banks and dollars.Blue line representing other currencies and yellow line representing Dollars. The market conditions does make itself almost impossible for any jurisdiction through respective central banks to regulate it. Usually central banks supervises banks within their jurisdiction so as to safeguard the depositors but for Eurocurrency the is limited or no supervision hence it can lead to collapse which could result in wiping out customers deposits like for the case of The Bank Ambrosiano Group. The Italian government only bailed out the domestic arm of the bank but not the Eurocurrency market based arm, a subsidiary. Eurocurrency Market Model According to Lipsey (1979) any loan should create a corresponding deposit (liability). Banks are required to maintain some deposits as reserves and this is a legal requirement in most countries and this according to multiplier approach. Eurocurrency escaping the radar of legal requirements of keeping some deposits as reserves has helped explain its exponential growth. However, banks have an obligation to self-regulate in order to safeguard interest of foreign depositors. According to profit-maximization school of thought, the deposits will always create the ratio of reserve and the challenge to banks is to raise deposits, which is equal to the loans. Banks therefore will participate in the Eurocurrency market to raise deposits to match their loan book. Firms can access a variety of financial services from Eurocurrency market .Among the financial services includes foreign currencies, Euro-commercial papers, Eurobond and foreign bonds. This financial services are attractive to firms because there little is regulation , little disclosure requirements and attracts less taxes.Eurocurrency from its name does not imply that the market is located in Europe. Eurocurrency market thrives in several countries majorly Singapore, Japan, Caribbean countries as well as Canada among others as demonstrated in table 2. The Dollar currency commonly traded away from US hence the term Eurodollar. However, for this specific situation Eurodollar implies deposits in form of dollars held in other countries not US. International based firms and even local based firms would benefit a lot if they participate in Eurocurrency market. Since there is little or no regulation by the government in the Euromarkets the borrowers as well as depositors would be encouraged to participate. For depositors, banks usually offer higher interest rates on Eurocurrency deposits compared to deposits on local currency hence attracting those investors having foreign currency. The Graph Showing the Relationship between Off- and Onshore Deposits and Lending Rates Source: Dufey and Giddy (1978, p 52). Conceptualizing the linkage between domestic and Euromarkets rates of deposit, Aliber (1980) and Kreicher (1982) used arbitrage tunnel. The basis of arbitrage was difference between LIBOR and cost of all domestic certificates, which actually result bid-ask price. The difference in pricing induced most firms and individuals to invest in offshore market due to attractive rates as compared to local deposits. With limited government interference, banks are able to extend loan facility in form of Eurocurrency at lower interest rate hence attracting borrowers. For example, a bank in London having deposits of 100 Pounds and 100 dollars. Due to government requirement of holding 10 percent in form of reserves the bank will be left with 90 pounds to lend hence reduced income in form of interest. Since there is no reserve requirement by government for the foreign currencies 100 dollars will be at the disposal for lending hence the interest earnings will be high. The intrigues of transactions and the cross-borders in Eurocurrency Market Transactions involving Eurocurrency are interbank and it usually crystallizes as interbank claims hence demonstrating a complex intermediary role of banks whose actions are on behalf of non-customers. As soon as a Eurocurrency bank receives a deposit, which is yet to be lent, the resultant action is to deposit it in another Eurocurrency bank. The bank lending out the money engages the services a broker, who in turn conceals the identities of prospective transactors until the final stage of the deal.The broker does this deliberately to secure interbank interest, which is best for party. This procedure avoids publicity hence enabling established firms to participate. For example a French customer can deposit 100000 USD in a London bank ,Standard Chartered. The bank then agrees to lend 90000 USD Bank of Australia, which is based in London. The two banks can having checking deposits with JP Morgan bank in New York. The accounts will reflect as follows: Interbank transactions in Eurocurrency (Eurodollar) market Standard chartered (London) ASSETS USD LIABILITIES USD Loan Bank of Australia 90,000 Customer deposit 100,000 Bank of Australia (London) ASSETS USD LIABILITIES USD Deposit with JP Morgan 90,000 Standard charted deposits 90,000 JP Morgan Bank ASSETS USD LIABILITIES USD Loan to bank of Australia 90,000 Deposit by Standard Chartered 90,000 Firms who seek to invest in Eurocurrency stand to benefit a lot. Firms will be able to avoid the tax burden be investing in destinations where there is little or no tax and this will increase the profitability of the firm. Also the organization will be able to somewhat escape the stringent central bank conditions that are sometimes more likely to inhibit the bank from achieving the full potential. In addition, the bank will be able to cushion itself from local inflation since the foreign currencies held by the bank is hardly affected by the localized inflation. Banks will also be able to facilitate international payments through their nostro accounts held in international banks. Banks investing internationally will be able to access cheap credit facilities as well as attract high interest rates for the offshore deposits. In conclusion, Eurocurrency market provide a variety of options for firms to invest nin offshore markets. Firms, which might have surplus funds, can loan out in foreign markets hence earning from high foreign interest rate. Also, firms participating in Eurocurrency market stands to benefit from exchange rate difference in the respective currencies which is favorable. Firms are also able to diversify risks, which has a ripple effect in the entire business environment, like reduction in insurance cost, which therefore result in overall productivity of the firm. Eurocurrency market stands to benefit the global economy if the financial service providers adheres to fiscal policies to enhance liquidity in the global market while providing avenues for cheaper capital movement. References Aliber, R (1980): “The integration of the offshore and domestic banking system”, Journal of Monetary Economics, vol 6(4), October, pp 509–26. John H. Makin, Capital Flows and Exchange-Rate Flexibility in the Post-Bretton Woods Era. (Feb. 1974) Kreicher, L (1982): “Eurodollar arbitrage”, Federal Reserve Bank of New York, Quarterly Review, vol 7, no 2 (Summer), pp 10–22. Read More