The Emergence and Innovations of the Eurodollar Money and Bond Market: The Role of Openness and Competition Between States

Regulation Q was introduced in 1933, relaxed in 1973 and finally abolished in 2011.

The graph is adapted from Boockmann and Vaubel (2009).

Foreign-currency deposits held by non-residents with banks in the UK (Quarterly Bulletin of the Bank of England). The share of the US dollar was approximately 85 %.

It is not clear how these statements are to be reconciled with Schenk (2002: 89) as quoted above. Burn, too, has changed his views. In 2006, he squarely supported the “market view” against the “state view” whereas in 1999 he called this “a false dichotomy” (p. 231).

In mid-1960, Swiss banks were asked not to accept short-term foreign currency deposits. France and Germany prohibited the payment of interest to foreign depositors. In December 1963, French banks were told to reduce their volume of Eurodollar deposits by three quarters. In France and Italy swaps from Eurodollar to local currency were prohibited. See Schenk (2002: 234, 237).

Cf. Helleiner (1994: 88, 90, 91) and Burn (2006: 147, 148).

Cf. Burn (2006: 135, 151–162, 166, 167) on the shifting attitude of the Treasury.

The Federal Reserve functions as agent of Congress, entrusting its constitutional power to “coin money, regulate the value thereof, and of foreign coin” (Art. I, Sect. 8). Though in accordance with written law, assignment of the central bank to the legislative branch and of the Treasury to the executive branch has to be qualified, taking into account that the President has the right to nominate Board members (cf. Meltzer 2009b: 830, 1142, 1189). Meltzer (2003, 2009a, b) observes the intricate relationship between both institutions over time.

A comprehensive overview checking arguments flawed and valid can be found in Johnston (1983: Chaps. 8–11).

The Eurocurrency market offered refuge to American capital persistently attempting to bypass controls and assisted foreign exchange dealers betting on revaluation (de Cecco 1987: 192). Exploiting the market as a liquidity reservoir, American banks countered the Federal Reserve’s decision to first restrict and then expand domestic credit in 1966/1967 and 1969/1970 (Meltzer 2009b: 701, 739, 740).

Cf. Helleiner (1994: 86), Meltzer (2009b: 695) and Burn (2006: 139).

Cf. Burn (2006: 164), Meltzer (2009b: 701) and Schenk (2010: 154, 155). No action was taken due to a negative ruling of the Board on the same subject in 1921 and a calming of the situation by fall 1966 (Meltzer 2009b: 701).

Cf. Meltzer (2009b: 740, 741). The requirement was due for transactions above a 3 % base of deposits and effective from October 16. Schenk (2002: 94) reports a 10 % reserve requirement by the Federal Reserve Bank of New York on net liabilities to foreign branches of US banks in excess of the average amounts outstanding in May 1969, effective in September 1969 already.

Cf. United States (1970: 375). Though these episodes suggest a purely domestic cause—the impediment of its instruments by the existence of the Eurocurrency market—for the decisions taken by the Federal Reserve, the international dimension is not to be neglected. Non-US monetary authorities repeatedly supplemented claims for long-term US fiscal discipline and anti-inflationary rigor with demands to take immediate regulatory action against the Eurocurrency market, cf. Meltzer (2009b: 701, 739–745), de Cecco (1987: 190) and Volcker and Gyohten (1992: 112).

This drawback of the Federal Reserve’s strategy of isolating the US domestic financial market is acknowledged by Burns (1988: 20).

Cf. Schenk (2010: 153, 157) and Burn (2006: 165). The volume of Eurocurrency transactions relative to US markets appears to have been a factor as well (Schenk 2010: 154).

Helleiner (1994: Chap. 5) traces the origins of the Treasury’s changing view during the Nixon administration and its effect on US international financial policy. After the fall of Bretton Woods American dominance relied on deep and liquid US financial markets attracting foreign investors, the leading international position of US banks and financial intermediaries, and the continued use of the dollar as a reserve currency (pp. 113–114).

Cf. de Vries (1985a: 315–339).

Cf. Key (1982a: 566). The proposal echoed requests of US banks in the early 1970s, cf. Key (1982b: 38) and Dale (1984: 22).

Cf. Helleiner (1994: 117, 118) as well as Volcker and Gyohten (1992: 113, 117).

Cf. Konings (2011: 124–128) on waning faculties of the Federal Reserve, due to continued innovation in American finance, and necessary adjustment of instruments and targets.

Cf. Meltzer (2009b: 893) and Board of Governors (1981: 571, note 2 to Table 6). Meltzer (2009b, 1000) gives October 5, 1978 as the starting date of the zero reserve requirement.

Cf. Meltzer (2009b: 960).

Cf. also Volcker and Gyohten (1992: 195, 196). During the international banking crisis of 1974, when the Federal Reserve had to manage the bail-out of Franklin National bank, similar cooperative action between central banks was induced, eventually leading to the BIS Accord of 1975, cf. de Cecco (1987: 194).

True, in 1969 the Federal Reserve approved the creation of Nassau ‘brass plate’ offices, helping Eurocurrency business to gain a footing in the Caribbean. Yet this was not a sign of Euromarket endorsement, but the result of choosing the lesser evil between open conflict with one of its interest groups and additional growth impetus for offshore banking, cf. Burns (1988: 20).

Cf. Key (1982b: 38) and Dale (1984: 22). In personal correspondence with the authors former staff of the Federal Reserve stated that the free banking zone was opposed by supervisory officials.

Henderson and Waldo (1980, 1981).

Lenience against inflation combined with ill-founded belief in a stable trade-off with unemployment is the central defect of American monetary policy at that time identified by Meltzer (2009b: 1223–1227).

Solomon at the Committee hearings on the Eurocurrency Market Control Act: “we don’t believe that pressures on the dollar originate as such from the fact that there are Eurocurrency markets”, US Congress (1979: 273). For regulatory topics discussed in this case study he is in many respects a key figure. As Undersecretary for Monetary Affairs he held the only position in the US administration, besides the Treasury Secretary himself, equipped with operational authority in domestic as well as international economic policy (Volcker and Gyohten 1992: 23, 232). In the fall of 1978 Solomon created the international rescue package to stop the dollar from depreciating, cf. Volcker and Gyohten (1992: 150). He was persuaded by Volcker to succeed him in January 1980 as President of the Federal Reserve Bank of New York where Solomon campaigned vigorously for establishing a Eurocurrency market in the US, cf. on the former Volcker and Gyohten (1992: 202) and on the latter Hawley (1984: 156) and New York Times (1980).

Cf. Axilrod (2009: 86) and Hawley (1984: 146, 148). An additional impetus offered to a reluctant Bundesbank for raising swap arrangements with the Federal Reserve was the acceptance by the Treasury to issue Carter bonds, US government securities denominated in German currency, cf. Putnam and Henning (1989: 85, 86). The appendix provides a detailed account of the German position on regulating the Eurocurrency market.

Meltzer (2009b: 962) and Helleiner (1994: 131) report the shifting attitude towards (international) policy coordination of US monetary authorities.

Meltzer (2009b: 926, 939, 966, 1007; and 847, 940, 1019, 1064) notes the outward pressure on and inner conflicts of the Board of Governors. Axilrod (2009: 86) alludes to possible reputational gains from acting against the Eurocurrency market. Helleiner (1994: 135) asserts the problems posed by the market to Volcker’s anti-inflation policy, the American Banker (1979b) his support for coordinated Eurocurrency reserve requirements.

For a useful chronology of events cf. Hawley (1984). Apparently, there were also plans to introduce the issue of Eurocurrency control at the G5 summit of Tokyo in June 1979, cf. the appendix on the German position.

Cf. Dale (1984: 42)

The idea was not new. Common Euro-reserve requirements had already been proposed in the early 1970s during the debate on international monetary reform, cf. the appendix outlining the German position. Details of the systems under review at the BIS can be found in Dale (1984: 27) and Axilrod (2009: 88)

On the role of international finance in US politics of the 1970s and 1980s cf. Cohen (1986: here pp. 135, 141 and 120). Dale (1984: 173) notes American scepticism about international standards in financial supervision and associated dispute with foreign regulators.

Testifying during the aforementioned Committee hearings Governor Wallich approved of the EMCA proposal, US Congress (1979: 183–189). His written statement includes the discussion paper, dated April 25, 1979 (pp. 208–213 in particular), cf. also Dale (1984: 27).

Cf. US Congress (1979: 5, 6). At the time of Congressional hearings on EMCA the relevant part of section 19(b) of the Federal Reserve Act read “The Board may, however, prescribe any reserve ratio, not more than 22 per centum, with respect to any indebtedness of a member bank that arises out of a transaction in the ordinary course of its banking business with respect to either funds received [from] or credit extended by such bank to a bank organized under the law of a foreign country or a dependency or insular possession of of the United States”, cf. Board of Governors (1972: 39).

Cf. US Congress (1979: 7).

Cf. US Congress (1979: 6, 7).

Cf. US Congress (1979: 8).

Both characteristics appear to be a particularity of the EMCA. At least they were not mentioned during BIS negotiations, cf. Dale (1984: 26–28) and Axilrod (2009: 88).

International Banking Facilities were specifically designed to deal with recycling: channelling funds from non-resident creditors, read oil-exporting countries, to non-resident debtors, non-OPEC developing countries, cf. for example Key (1982a).

Treasury Secretary Blumenthal established the link between Eurocurrency Market Control Act and energy crisis, cf. American Banker (1979c).

Since the mid-1960s US intermediaries dominated the Eurocurrency market, cf. Cassis (2006: 226, 227) and Sylla (2002).

Quoted by Hawley (1984: 157, 158).

A short proviso with relation to data presented below and conclusions derived from them to caution the reader: measuring the size of the Eurocurrency market is one tall task, fuelling a history of dispute among academics and practitioners as old as the market itself; in addition, comparability of quantitative information over time suffers from multiple breaks in series resulting from changes in the number of banks or types of transactions covered by statistics. The figures below generously neglect such problems, resorting to analysis of market shares, a relative measure, but hoping to still be able to catch the gist of evolution in Eurocurrency business.

The European reporting area consisted of Belgium, France, Germany, Italy, Luxembourg, the Netherlands, Sweden, Switzerland and the United Kingdom. BIS considered only two non-European countries in its original panel of reporting banks, Canada and Japan.

One of the main reasons for the City’s accomplishment is directly connected to the theme of the case study: at the time regulators in other European countries had shown far less benevolence towards banking business with foreign customers than their British counterparts, cf. Schenk (2002: 86).

Cf. Cassis (2006: 226, 227).

Starting with the last quarter in 1973 the BIS reported positions of branches of US banks in the Bahamas, the Cayman Islands, Panama, Hong Kong and Singapore.

International financial centres are characterised by exercising mainly redistributive duties, channelling funds received from foreign creditors to foreign debtors. Funds entering (switch in) or leaving (switch out) the host jurisdiction on the other hand, inducing net capital flows, are of secondary importance.

The marked net-creditor position during the 1960s exemplifies the central role of international banks in pooling and rechanneling dollar funds to the United States.

In addition to jurisdictions mentioned in connection with foreign branches of US banks BIS statistics record reporting banks’ positions vis-à-vis offshore centres as transactions with customers in Barbados, Bermuda, Lebanon, Liberia, the Netherlands Antilles, Vanuatu, and other British West Indies.

In fact, of 29 countries and jurisdictions the BIS after December 1973 admitted to its reporting area 17 are located outside this developed core.

Cf. Dale (1984: 27).

Offshore financial centres mentioned before did not participate in negotiations. Still, with the threat of US-initiated regulation looming over Eurocurrency business they established the Offshore Group of Banking Supervisors in 1980. It was based on the “new perception . . . that they have common interests and that they will benefit from increased co-operation between themselves” (McMahon 1982: 266). Perhaps unsurprisingly, the Bank of England can “claim some credit for the emergence of this group” (ibid.).

Governor Wallich quoted Richardson’s disapproval while testifying on EMCA, cf. US Congress (1979: 239). The British point was also driven home by a senior official from the Bank of England visiting Axilrod, Chairman of the BIS sub-committee on Eurocurrency reserve requirements, at the Federal Reserve, cf. Axilrod (2009: 88, 89).

The relationship between fiduciary and Eurocurrency business as well as its importance for Swiss banking are documented in Dale (1984: 37). Leutwiler’s concern is quoted in American Banker (1979c).

The first quotation is a statement by Jean-Nicolas Schaus (Dale 1984: 36). The Deputy Commissioner of Banking alluded to the Luxembourg economy and government relying heavily on revenue created by the financial sector, cf. Dale (1984: 34–36) and the references given therein. Consequences for national legislation were observed by Pierre Jaans, Commissioner of Banking Control in Luxembourg, cf. International Herald Tribune, November 27, 1979: 14S.

The difficulty of achieving agreement on coordinated reserve requirements in a world of diverse national approaches to banking supervision and monetary policy is noted by International Herald Tribune, November 27, 1979: 14S, Bundesbank (1980: 53) and Dudler (1983: 132). Dale (1984) documents how the Bank of England dealt with the existence of the Eurosterling market (p. 39), and recounts the Bundesbank’s dilemma in seeking revision of central bank law (p. 27).

Cf. Cohen (1986: 218).

US Congress rejected the EMCA proposal after Committee hearings in 1979, while in April 1980 participants in BIS negotiations voted overwhelmingly against coordinated reserve requirements, cf. Helleiner (1994: 137, 138) and Dale (1984: 28). Also not leading to results was a follow-up letter by President Carter of April 1980 asking foreign central bankers to keep their intermediaries’ lending to US residents in line with his administration’s anti-inflation programme, cf. Dale (1984: 25, 26).

The retracing of events follows Key (1982a: 565, 566) closely.

Cf. Wall Street Journal, March 14, 1978, p. 34. Governor Carey was hoping for 4,000 additional jobs created through the establishment of IBF. State governments were a vital driving force in the process of deregulating US financial markets (Burns 1988: 23). The Federal Reserve put the proposal on hold and deferred judgment, in December 1978 to seek comment on certain features and perform further analysis (Key 1982a: 566), in November 1980 to accord state legislators tracking the New York example more time (Washington Post, November 20, 1980).

In personal correspondence former staff of the Federal Reserve reckoned that the central bank might have been afraid of an even more daring approach to IBF by the Republican administration or the new Republican majority in the Senate.

Key and Terrell (1988, b: 194) indicate the importance of the Monetary Control Act, cf. also Meltzer (2009b: 925, 1052; 1013, 1066–1068, 1157). For Solomon’s attitude towards an American Eurocurrency market cf. Hawley (1984: 156), and more generally Helleiner (1994: 138).

Cf. McMahon (1982: 267). Before the Federal Reserve changed strategy and entered regulatory competition the “race to the bottom” argument was acknowledged by its staff too, cf. Dale (1984: 30).

Nevertheless, IBF did function as a role model. The establishment of the Japanese Offshore Market in December 1986 is a prime example, not least because government, Bank of Japan and interest groups retraced almost step for step the protracted struggle of their American opposits, cf. Dale (1984: 43, 44).

Key (1982a: 566–569) offers a detailed report on IBF technicalities. This subsection highlights only those relevant to the case-study’s subject.

When doing business with foreign affiliates of US residents IBF entities were required to explicitly inform customers of this prohibition. The transmission of this information had to be verified by a written acknowledgment of the customer.

Of the studies cited in this section, Key (1982a, b), Key and Terrell (1988, b) and Moffett and Stonehill (1989) provide a general account of IBFs’ first years of operation.

Cf. the restrictions on business with nonbank customers mentioned before, Key (1982a: 566) and Key and Terrell (1988, b: 195). Consequently in the first years of operation the share of nonbank business intermediated via IBF was well below 30 % for claims and about 16 % for liabilities (both shares include transactions with foreign governments and official institutions), considerably lower than in other Eurocurrency financial centres, cf. Chrystal (1984: 7). The issuance of negotiable instruments, especially Eurodollar certificates of deposits, was an important driver of business with non-US residents for London in the 1980s, cf. Key and Terrell (1988, b: 212).

Cf. Key (1982a: 569–575) and Key and Terrell (1988, b: 198–207).

On a side note, but in view on the subject of this case study, the introduction of IBF led to considerable tax competition among US states, cf. Chrystal (1984: 6).

Cf. Chrystal (1984: 10). Key and Terrell (1988, b: 202) are more cautious in their assessment of tax incentives. Due to this unattractiveness to foreign banks, IBF business conducted in US dollar was approximately 97–98 %, well above the share of regular financial centres, such as London, cf. Key (1982a: 571) and Key and Terrell (1988, b: 201).

Cf. Key (1982a: 571).

Cf. the econometric study by Terrell and Mills (1983).

The dispute between pro-market Republican and interventionist Democratic administrations translated into the practice of international monetary policy beyond the Eurodollar issue. Eisenhower, challenged by sizable gold outflows at the end of the 1950s, refrained from imposing restrictions on trade in goods or financial claims, and instead resorted to policies keeping federal expenditures in check and domestic inflation down (Meltzer 2009a: 185; Gavin 2004: Chap. 2). Nixon, as was already noted in section A Rift Between US Monetary Authorities (1973/74), dissolved the international monetary order of fixed parities and promoted free capital movement. Reagan acquitted monetary authorities from intervening in foreign exchange markets (Meltzer 2009b: 1071 and 1134). In contrast, Kennedy and Johnson introduced measures to curb US capital outflows and demanded support by the Federal Reserve to contain repercussions from inconsistent national and international policy goals (Meltzer 2009a: 36, 37, 278, 279). Carter wanted large-scale international cooperation to stabilize the dollar and foster economic growth (Putnam and Henning 1989).

Until the end of the 1970s the Federal Reserve advocated price and wage controls as effective instruments to restrain inflation (Meltzer 2009a: 16, b: Chap. 6), supported the fixed parities of Bretton Woods alongside restrictions on capital movement and, after its fall, foreign exchange intervention, cf. section A Rift Between US Monetary Authorities (1973/74) and Meltzer (2009b: 1071). Meltzer (2003: Chaps. 5 and 6) offers a minute analysis of the Federal Reserve during and after the Great Depression; A monetary history of the United States, the indictment assembled by Milton Friedman and Anna J. Schwartz, started its influential journey in 1963.

The Treasury’s volatile position on Eurocurrency markets decomposing well along partisan lines of economic thinking, the Federal Reserve’s general suspicion of markets—more emphasis on both drivers of regulation and competition in Eurodollar business was recommended to us by former senior staff of the US Treasury.

Cf. Kapstein (1994: 113–119).

Hayek (1976) was among the first to argue that free choice in currency tends to keep inflation low. Several econometric studies show that freedom of capital movements and inflation bear a significantly negative correlation (Grilli and Millesi-Ferretti 1995; Gruben and McLeod 2002; Tytell and Wei 2004).

This is not to deny that banks ought to be subject to special, and indeed high, capital requirements.

Nor was the crisis caused by the repeal of the Glass Steagall Act in 1999. The crisis did not start with the commercial banks but with investment banks like Lehman Brothers.

William Roberds has pointed out to us that, during the financial crisis, the Eurodollar interest rate tended to be higher than the federal funds rate in New York (McAndrews 2009). This led the ECB, the Bank of England, the Swiss National Bank, the Bank of Japan and some other central banks to make available U.S. dollars provided by the Federal Reserve under the Central Bank Swaps program. We do not believe that this temporary interest differential played a major role in the financial crisis nor that it would have done so if the swaps program had not been agreed. Such interest differentials are to be expected because Eurodollars are also traded by non-depository institutions and because Eurodollar trades cannot be settled directly between borrower and lender using the Federal Reserve’s Fedwire Fund Service.

The incompatibility of policies and its positive effect on the growth of the Eurocurrency market is noted by de Cecco (1987: 190). British monetary authorities were exempted from the policy complications faced by their American and German counterparts. They were able to actively pursue a strategy of regulatory competition with other jurisdictions because they promoted the London financial centre as an entrepôt, redistributing capital from foreign lenders to foreign borrowers.

If London was the first adversary to American regulators, then for the Germans this part was taken over by Luxembourg, cf. Dale (1984: 34, 41). Coordinated regulation of the Eurocurrency market seemed also necessary to them, because EEC members were taking first steps to financial integration, cf. Schenk (2010: 161).

Schenk (2010: 159, 160) examines talks in great detail. Her view, however, is not undisputed: Helleiner (1994: 118, fn. 65) reports sympathy in the Federal Reserve towards restricting the placement of official reserves while Hawley (1984: 142) sees BIS itself as the main proponent. The Group of Ten countries are Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, United Kingdom and the United States. Luxembourg is an associate member.

Consequently, during meetings with the remaining members of the European Economic Community (EEC) in March 1973 in Paris on the joint float of six EEC currencies the Group of Ten wanted to investigate possibilities of extending the agreement to member nations of the International Monetary Fund, cf. de Vries (1985b: 631). One year later, coming to terms with repercussions of the first oil shock, the Committee of Twenty of the IMF proposed to restrict placements in the Eurocurrency market by public entities, albeit without success, cf. Schenk (2010: 160). During the dollar crisis of the late 1970s the central bank governors confirmed their 1971 commitment, Bundesbank (1979: 55).

Cf. Schenk (2010: 162–164).

Cf. Schenk (2010: 161). The proposal echoed investigations on Eurocurrency reserves that were suggested by the Group of Ten in their Communiqué of the same month on the joint float of six EEC currencies, cf. de Vries (1985b: 631).

Cf. Bundesbank (1976: 62). In the relevant passage on IMF reform the Committee stated that “The amended Articles of Agreement should include a provision by which the members of the Fund would undertake to collaborate with the Fund and with other members in order to ensure that their policies with respect to reserve assets would be consistent with the objectives of promoting better international surveillance of international liquidity”, cf. de Vries (1985b: 227).

Cf. Bundesbank (1979: 55).

Cf. Volcker and Gyohten (1992: 112). Schmidt is also credited with introducing the term “xenocurrency” to non-academic usage as a replacement for “Eurodollar” or “Eurocurrency”, cf. Newsweek (1979: 37).

Cf. New York Times, September 8, 1972: 45 on the former and Volcker and Gyohten (1992: 112, 113) as well as New York Times, March 17, 1973: 1 on the latter.

Paraphrasing Schmidt’s answer in an interview to the question on whether Eurocurrency markets drifted already beyond control of individual governments. The original reads: “Ich bemühe mich – und das habe ich gegenüber Präsident Nixon getan, das werde ich gegenüber Präsident Ford wieder aufnehmen – die Regierungschefs der großen Partner der Weltwirtschaft – und das sind Amerika, Frankreich, England, Deutschland und Japan – davon zu überzeugen, da es dringend notwendig ist, unsere Zentralbanken zu einer noch viel engeren Kooperation zu bringen als bisher. Damit soll anders als bis heute in Zukunft auch die Kreditaktivität auf den irreführend so genannten Eurokreditmärkten voll unter Notenbankkontrolle gebracht werden”, cf. Der Spiegel (1974: 19). He liked to achieve a common supervision by central banks (ibid. p. 20). Schmidt’s remarks were also noted by major East Coast publications in the United States, cf. New York Times, August 22, 1974: 47 and Wall Street Journal, August 30, 1974: 4.

Putnam and Henning (1989) provide an extensive account of events. The main side payment Schmidt wanted from President Carter was the de-control of US energy prices, enacted on April 5, 1979. In passing, note that Anthony Solomon again was involved: he participated in pre-summit negotiations (ibid. p. 19).

Cf. International Herald Tribune, November 27, 1979: 14S.