5. Eurocurrency Market (International Money Market)

All the world's currencies that are banked outside their countries of origin are referred to as Eurocurrency and traded on the Eurocurrency market. Thus, U.S. dollars deposited in a bank in Tokyo are called Eurodollars and British pounds deposited in New York are called Europounds. Japanese yen deposited in Frankfurt are called Euroyen, and so forth.

Because the Eurocurrency market is characterized by very large transactions, only the very largest companies, banks, and governments are typically involved. Deposits originate primarily from four sources:

• Governments with excess funds generated by a prolonged trade surplus

• Commercial banks with large deposits of excess currency

• International companies with large amounts of excess cash

• Extremely wealthy individuals

Eurocurrency originated in Europe during the 1950s-hence the "Euro" prefix. Communist governments of eastern European nations feared that they might forfeit dollar deposits made in U.S. banks if claims were filed against them by U.S. citizens. To protect their dollar reserves, they deposited them in banks across Europe. Banks in the United Kingdom began lending these dollars to finance international trade deals, and banks in other countries (including Canada and Japan) followed suit. The Eurocurrency market is valued at around $6 trillion, with London accounting for about 20 percent of all deposits. Other important markets include Canada, the Caribbean, Hong Kong, and Singapore.

Appeal of the Eurocurrency Market Typically, governments strictly regulate com­mercial banking activities in their own currencies within their borders. For example, they often force banks to pay deposit insurance to a central bank, where they must keep a certain portion of all deposits "on reserve" in non-interest-bearing accounts. Although such restrictions protect investors, they add costs to banking operations.

The main appeal of the Eurocurrency market is the complete absence of regulation. The absence of regulation and its resulting lower costs mean that banks can charge borrowers less, pay investors more, and still earn healthy profits. In addition, extremely large transactions considerably reduce transaction costs. Moreover, interbank interest rates - rates that the world's largest banks charge one another for loans-are determined by the free market. The most commonly quoted rate in the Eurocurrency market is the London Interbank Offer Rate (LIBOR)-the interest rate that London banks charge other large banks that borrow Eurocurrency. The London Interbank Bid Rate (LIBID) is the interest rate offered by London banks to large investors for Eurocurrency deposits.

Interbank interest rates

Interest rates that the world's largest banks charge ore another for loans.

An unappealing feature of the Eurocurrency market is greater risk: Government regulations that protect depositors in national markets are nonexistent. However, despite the greater risk of default, Eurocurrency transactions are fairly safe because of the size of the banks involved.