Eurodollar

What It Is

A eurodollar is U.S. currency held in banks outside the U.S. (typically in Europe). Eurodollars are not the same thing as euros, the currency of the European Union.

How It Works

The eurodollar market began in the 1950s, when the Soviet Union began moving its dollar-denominated oil revenue out of U.S. banks in order to prevent the U.S. from freezing its assets.

Let's assume XYZ Company moves $10 million from its Wells Fargo account in New York to a London bank. XYZ Company receives a eurodollar time-deposit certificate from the London bank. The London account balance is in dollars, and any interest earned on the account accrues in dollars as well. The London bank may use the funds to make loans, perhaps in the United States. Most eurodollar deposits pay interest and have fixed maturities (since they are time deposits).

Dollars do not have to be deposited in a European bank to be considered eurodollars; the Bahamas, the Cayman Islands, and non-European countries are also popular. Foreign branches of American banks can also accept eurodollars.

The eurodollar market includes U.S. and foreign corporations, individuals, and foreign governments. London is a major eurodollar center because its markets operate during the American and Asian markets.

The markets depend on a supply of depositors willing to move their dollars from American banks to foreign banks. Eurodollar banks could have liquidity problems if this supply falls, and many banks have standby lines of credit with U.S. banks to prevent this.

Why It Matters

The eurodollar market is one of the world's primary international capital markets, and companies use eurodollars to settle international transactions, invest excess cash, make short-term loans, and finance imports and exports.

One of the biggest reasons the eurodollar market is popular is that eurodollar deposits are not subject to American banking regulations. Because the deposits are outside of the United States, the banks holding these deposits do not have to adhere to the Federal Reserve's reserve requirements, and the Securities and Exchange Commission does not regulate eurodollar securities.

Many banks and corporations find the lack of regulation attractive because it lowers costs, increases flexibility, and allows for creative structuring of financial instruments. This is why some U.S. companies raise money in the eurodollar markets when U.S. markets are unfavorable. As a result, many securities are denominated in eurodollars, as are the interest, principal, or dividend payments associated with them. Sometimes American companies even create two-tranche IPOs, where one tranche trades on U.S. exchanges and the other trades on a European exchange. Other eurodollar securities, such as eurodollar bonds, pay investors in U.S. dollars but do not have to comply with SEC regulations. In 1981, the Chicago Mercantile Exchange began trading eurodollar futures, which were the first futures contracts that did not require delivery of an underlying instrument but were instead settled in cash.

Source: Investing Answers