5.2 The ‘parallel’ markets

Eurocurrency:Currency held outside its country of origin. A eurocurrency instrument

is an instrument denominated in a currency different from that of the country in which

it is trading.

Under the Bretton Woods system of xed exchange rates established after the

Second World War, the US$ functioned as an intervention currency, an international

means of payment and store of value. The worldwide demand for dollars was met

by a combination of US balance of payments decits and dollar borrowings from

US banks, the resulting deposits being held until the early 1960s, mainly with US

banks. In the mid-1960s, however, the US authorities began to impose controls

on currency outows which limited access to these (US-stored) deposits for over-

seas owners. This combined with two further, long-running disadvantages. The

rst was ‘regulation Q’ which limited interest payments on deposits. The second,

mainly relevant to Eastern bloc countries, was the risk that dollar deposits might

be impounded for political reasons. The result was that non-US owners of dollar

deposits began to place them with European banks and, later, with European sub-

sidiaries of US banks.

Since reserve, deposit insurance, capital and other regulatory requirements are

usually imposed with respect to banks’ holdings of deposits in the domestic currency

and act as a tax on deposit business, a further contributory factor to the long-term

growth of eurocurrency business was the ability of eurobanks to offer their services

at more competitive rates than domestic institutions. ‘Eurobanks’ is actually some-

thing of a misnomer. Most are departments or subsidiaries of major banks with a

clear national identity. Most countries are involved, although the largest shares lie

with banks whose headquarters are in Japan or the US.

There is nothing fundamentally different between a bank which specialises in

eurocurrency business and a bank which concentrates on domestic deposits and

lending, from an economic point of view. Both help channel funds between surplus

and decit units and, in so far as they create assets and liabilities which are more

attractive to end-users than would be the case if the latter dealt directly with

each other, they help to mobilise funds which might otherwise have lain idle. One

potential consequence of the development of eurocurrency markets, however, is

that they contribute to the difculties which central banks face in operating their

domestic monetary policy. We shall see in section 5.3 that direct controls on bank

lending have been out of fashion for the past twenty years. One reason for this is

that such controls can apply only to domestic banks conducting their business in

sterling. With no foreign exchange controls and active eurocurrency markets, it

is an easy task for a UK bank, denied the ability to lend to a customer in sterling,

to arrange a eurocurrency loan with a subsidiary and then swap the proceeds into

sterling. In section 3.4.3 we discussed the possibility of the central bank controlling

the quantity of bank reserves in order to restrict lending. This too would suffer the

same fate. UK banks would simply divert business to banks offering eurocurrency

facilities and take a commission on the deal.

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Chapter 5 • The money markets