The monetary fifth column: the Eurodollar threat to financial stability and economic sovereignty.

• Author: Fowler, Stephen A.

ABSTRACT

Eurodollars are dollar-denominated deposit liabilities of banks outside the United States. Even though estimates of the size of the Eurodollar market exceed $5 trillion, these instruments are virtually unregulated. Legal scholarship has very little to say about Eurodollars, and the economic literature on the subject is geared toward economists and banking professionals rather than policy makers and attorneys. Furthermore, the economic scholarship is focused on describing the way Eurodollar markets function rather than critical examination of their nature and attendant risks. This Note is an attempt to get to the bottom of this ubiquitous yet mysterious financial instrument. It describes the nature and history of the Eurodollar and discusses potential challenges the Eurodollar market poses to financial stability and monetary sovereignty. It then examines the evolution of international bank regulation, pointing out why current measures are insufficient to address the risks posed by the Eurodollar. Finally, it considers possible solutions to these problems and proposes an approach to regulating the Eurodollar market consisting of a scheme of international reserve requirements.

TABLE OF CONTENTS I. INTRODUCTION II. BACKGROUND A. What Is a Eurodollar? B. A Brief History of the Eurodollar C. Eurodollar Uses D. Expanding Balance Sheets and Clearinghouse Concerns E. The Eurodollar and Foreign Bank Bailouts III. STABILITY AND SOVEREIGNTY ISSUES A. Central Banks and Control B. Global Financial Stability: Eurocurrencies Pose Systemic Risk IV. INTERNATIONAL REGULATORY REGIMES: BRETTON WOODS AND THE BASEL ACCORDS A. International Monetary Agreements: From Bretton Woods to Basel II B. Basel Failures C. Basel III--Another Half-measure V. POSSIBLE SOLUTIONS A. Introduction: Action vs. Inaction B. Unilateral Action 1. Unilateral Elimination of the Eurodollar 2. Host Country Regulation 3. Shortcomings of Unilateral Regulation C. International Agreements 1. Multilateral Agreements Imposing Reserve Requirements 2. Elimination of the Eurodollar by International Agreement 3. Obstacles to International Agreements 4. Disclosure Requirements D. Consequences of Continued Inaction VI. Conclusion I. INTRODUCTION

In 2008, at the height of the financial crisis, the biggest beneficiaries of the Federal Reserve's emergency loans were not American banks but European ones. (1) By means of an interbank transfer called a foreign central bank liquidity swap, the U.S. central bank lent nearly $600 billion to foreign central banks. (2) The Federal Reserve reopened these dollar-liquidity swap lines during the Eurozone crisis, loaning ailing foreign institutions an additional $109 billion. (3) At the center of these foreign bank bailouts was a financial instrument called the Eurodollar.

Outside of the world of traders and economists, little is spoken of the Eurodollar. For most attorneys, indeed for most people, the words Eurodollar or Eurocurrency probably bring to mind the transnational currency introduced in 1999 and currently used as the medium of exchange in eighteen European nations. (4) However, a Eurocurrency need not have any relation to Europe or the Euro. A Eurocurrency is a deposit liability issued by or "held by" (5) a bank located in one country but denominated in units of another country's currency. (6) A Euro dollar, for example, is a type of Eurocurrency consisting of a U.S. dollar-denominated deposit in a bank outside the United States. (7) While this is a benign enough definition, Eurodollars comprise an estimated $5 trillion market (8) and present all the attendant risks of such a large market. (9)

Despite their prevalence, Eurodollars are some of the least understood financial instruments. Describing them in 1969, decades after their initial creation, (10) the preeminent economist Milton Friedman wrote that Eurodollars were "the latest example of the mystifying quality of money creation to even the most sophisticated bankers, let alone other businessmen." (11) After recounting a story where a "high official of an international financial organization" gave an explanation of Eurodollars that was "almost complete nonsense," Friedman went on to refer to them as nothing more than the creation of a "bookkeeper's pen." (12)

Given this lack of understanding, it should come as no surprise that the Eurodollar market is largely unregulated. (13) This presents a number of problems. First, due to the sheer size of the Eurodollar market, its failure poses systemic risk. (14) A second obstacle is equally problematic. Because Eurodollars represent a market for dollars that is not controlled by the Federal Reserve, it has the potential to affect or even undermine the Federal Reserve's ability to control the supply of U.S. dollars. Thus, the Eurodollar represents a potential abrogation of national monetary sovereignty. (15) This threatens not only the financial markets, which rely on the effectiveness of Federal Reserve controls, but also the ability of the United States to set its own monetary policy.

This Note analyzes the economic and sovereign risks posed by the continued lack of regulation of the Eurodollar market. Its purpose is to demystify the Eurodollar in hopes that a greater understanding of this instrument will encourage the legal community to assume a larger role in creating rules governing such financial instruments. Part II provides relevant background on the emergence and current state of the Eurodollar market, including a description of the U.S. Federal Reserve bailout of foreign banks during and in the wake of the financial crisis. Part III discusses the Eurodollar market's potential threat to financial stability and analyzes the implications of the Eurodollar market on national sovereignty. Part IV analyzes potential remedies by analogy, examining schemes used to address earlier problems in international finance, specifically, the Breton Woods Agreement and the Basel Accords. Part V discusses possible solutions and recommends that the United States advance an international scheme imposing reserve requirements on institutions holding Eurodollars and provide for an international clearinghouse for Eurodollar transactions. Part VI concludes that global financial stability demands prudent regulation of the Eurodollar market.

2. BACKGROUND

   1. What Is a Eurodollar?

      In order to understand what a Eurodollar is, it is important first to understand the nature of a bank deposit. A bank deposit (or "demand deposit" because it is available on demand) is not, in fact, a bailment. (16) The bank is not "holding" the depositor's cash as a parking garage would hold one's car. When a depositor makes a deposit, the funds become the property of the bank, and, in exchange, the depositor receives a claim against the bank for the amount of the deposit. (17) The bank "buys" the cash in exchange for a short term IOU (representing the bank's deposit liability). (18) Thus, the relationship between the bank and depositor is more like a contractual relationship than a relationship between a bailor and bailee. (19)

      A certificate of deposit (CD) is a type of deposit that serves as a good demonstration of this concept. A CD is a deposit, evidenced by a certificate, which matures after a specific amount of time (which is why it is called a time deposit). (20) The purchaser of the CD can redeem their certificate for its value at the maturity date, but the bank is not simply holding the money of the CD owner. The deposit itself is an instrument of value, not just a log of the amount of money given to the bank. (21) The same principle applies to basic deposits, albeit without the maturity date or actual certificate.

      At the most basic level, Eurodollars are "deposit liabilities, denominated in dollars, of banks outside the United States." (22) In other words, they are short term IOUs for dollars that are issued by banks outside the United States. This means that even though these banks are in other countries, there is no exchange rate (a Eurodollar is worth the same as any other dollar), and, at least in theory, a cash payment of dollars will satisfy a bank's Eurodollar liability. (23) They are very close substitutes for U.S. dollars.

      Like CDs, virtually all Eurodollars are time deposits. (24) These time deposits mature at various rates, ranging from overnight to several years (maturities greater than a year are technically Eurobonds), but most mature between one week and six months. (25) Thus, a more precise definition of Eurodollars is that they are dollar-denominated time deposit liabilities of non-U.S. institutions. (26)

      Eurodollars are created when dollar balances are transferred from a bank branch in the United States to a bank branch abroad. (27) For example, suppose an investor, John, wants to open an account at Citibank in London and funds the account with a $1,000 check from his Chase account in New York. 28 John is essentially exchanging his deposit in New York for an equivalent deposit in London. Functionally, the two assets are the same to John, but while John's deposit at Chase was a demand deposit, his deposit at Citibank in London is a Eurodollar deposit.

      Furthermore, even though John makes his deposit in London, no actual cash leaves the United States. When John deposits his check, Chase transfers $1,000 to Citibank. However, Chase transfers the money to Citibank in New York. More accurately, Chase transfers $1,000 in reserves from its own account at the New York Federal Reserve to Citibank's account at the New York Federal Reserve. (29) As a result, Citibank New York "owes" money to Citibank London. (30) This "debt" is settled by adding $1,000 to Citibank London's New York dollar account (essentially a checking account that the London branch holds at the New York branch). (31) At the end of the transaction, Citibank London has a $1,000 Eurodollar liability to John with an offsetting credit from Citibank New York, and Citibank...