Where did the Eurodollar Market come from? How did this system arise?

Where Did The Eurodollar System Come From?

This is the subject of great debate. Considerable research was done, in hindsight, to pinpoint the start and what caused it. There are many theories including the Russians desire to keep money away from the US government or higher interest rates internationally as a result of Regulation Q.

While these are a part of the equation, they are not mostly the main driver. Ironically, regulation and government might be the reason the establishment of the Eurodollar System.

And that at fault was Britain herself.

Regulation And Capital Flows

We can look to the mid 1950s in London as the onset of the Eurodollar System. While the US dollar is at the center of the story, it is the London banks, the sterling, and the Bank of England that are the important actors.

It all begins with the British government having inconsistent policies on capital flows. The policy moves from liberalization and attempts to mitigate its effects.

In 1957, there were exchange controls were implemented that barred the use of sterling to finance foreign trade between 3rd parties while outlawing the refinance credits in that currency.

The response by London banks, especially Midland, was to start using dollar deposits.

This process, however, was started before this.

Midland Bank

It was in June 1955 that Midland Bank was known to be seeking foreign deposits unrelated to their commercial transactions. This signaled they were borrowing US dollars to obtain sterling.

The deposits were attracted to solve specific liquidity constraints and in response to profitable opportunities in the United Kingdom.

Essentially, this started interest arbitrage between New York and London. Due to Regulation Q, which capped the interest on short term deposits, money started to flow east. The yields on UK treasuries jumped as capital moved in.

Once the banks could cover the swaps between USD and sterling in the forward [market])https://leofinance.io/@leoglossary/leoglossary-market), interest arbitrage became possible.

This started the process of sending dollars into the system, spurred on by this trade. Banks such as Midland were able to borrow the USD to get sterling which it then used for [investment](https://leofinance.io/@leoglossary/leoglossary-investment within the) U.K.

Environment Ripe For The System

This period is when Bretton Woods was still new. It is vital to remember this was designed to restrict capital flows which they believed led to the competitive devaluation in currencies during the 1930s. The view was that speculation was at the root of the problems and the system was designed to deter that.

The result was the Eurodollar System. This allowed speculators and the financial market to overcome the capital restrictions by borrowing directly abroad.

It is what Midland Bank, among others, took advantage of.

So while Bretton Woods provided the field for this system to arise, it was London which became the epicenter.

The ground was fertile because:

• there was tight money
• the self-denying ordinance among banks not to bid competitively for sterling
  deposits
• the main regulatory factors were controls on interest paid on USD deposits in the U.S. which created a demand for a new product
• the opening the forward exchange market to domestic U.K banks which allowed the them to offer the product

All of this started the Eurodollar System. This is long before different entities such as BIS tracked what was going on (1963).

The End Of Bretton Woods

Bretton Woods was failed from the beginning. While it did have some positive effects such as exchange rate stability and helped to foster economic growth, the fact it was without an international currency, i.e. unit of account, meant another system had to develop.

The fact that it sought to restrict capital flow meant that the financial system had to take other steps. Banks were not going to let demand go unanswered due to tight monetary conditions put forth by the central banks and bureaucrats.

What caused the downfall was the Eurodollar System. This operates outside the central banks, governments, and regulators. The role of finance is to provide liquidity and that is what financial institutions do.

Whereas they tried to restrict the flow of capital, the Eurodollar System provided the liquidity required for global trade.

It all got its start in the mid-1950s.

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