Eurodollar Market: Offshore Dollar Funding Explained

Key Takeaways

• The Eurodollar market holds roughly $10 trillion of offshore dollar claims, with London, Tokyo, Hong Kong, and the Cayman Islands as major booking centers, the name has nothing to do with Europe or the euro.
• When offshore dollar funding seizes, as in September 2008 and March 2020, the Fed must extend swap lines to foreign central banks to prevent a global dollar shortage from collapsing non-US bank balance sheets.
• Investors confuse Eurodollars with the euro currency; Eurodollars are US dollars held outside the US, a term coined in the 1950s describing location, not denomination.
• SOFR replaced USD LIBOR as the reference rate for Eurodollar-linked contracts, but the underlying offshore deposit market still exists and continues to grow, what changed is the benchmark, not the plumbing.

What It Is

A Eurodollar is a US dollar denominated deposit held at a bank located outside the United States, regardless of whether that bank is European. A dollar on deposit at a London branch of a Japanese bank is a Eurodollar. A dollar on deposit at a Cayman subsidiary of a US bank is also a Eurodollar.

The term comes from the 1950s, when Soviet and European holders moved dollar deposits to London to avoid US regulation. The "Euro" prefix stuck even as the market expanded globally. Modern estimates put offshore dollar liabilities at roughly $10 trillion, with London, Tokyo, Hong Kong, and the Cayman Islands as major booking centers.

The Intuition

Dollars are the world's invoice currency, reserve currency, and collateral currency. Most global trade is priced in dollars, most cross-border debt is issued in dollars, and most derivatives settle in dollars. Non-US banks need dollar funding to finance all of that activity, but they cannot borrow directly from the Federal Reserve's discount window.

The offshore market exists to fill that gap. A German exporter that invoices a Chinese buyer in dollars will eventually deposit those dollars somewhere. That deposit funds a loan to another borrower who needs dollars. The whole system operates in parallel to the domestic US banking system, using the same currency but outside the Fed's direct regulatory reach.

How It Works

The offshore dollar market has three main layers:

Layer 1: Interbank deposits (Eurodollar deposits, CDs)
Layer 2: Short-term funding (commercial paper, repo)
Layer 3: FX swaps and cross-currency basis swaps

A typical funding chain:

1. A non-US bank borrows dollars in the interbank market or issues dollar commercial paper.
2. It lends those dollars to corporate clients, buys US Treasuries, or funds a trading book.
3. If dollar deposits run short, it uses FX swaps to convert local currency into dollars, paying the cross-currency basis.
4. In extreme stress, its home central bank draws on a Fed swap line and redistributes dollars to domestic banks.

Settlement uses the correspondent banking system. Non-US banks hold dollar nostro accounts at US banks, and interbank transfers clear through CHIPS in New York, usually same-day. Cross-border messaging runs over SWIFT.

Eurodollar futures, once the world's most actively traded short-term rate contract, referenced three-month USD LIBOR. Those contracts transitioned to three-month SOFR futures after LIBOR cessation in June 2023.

Worked Example

A Korean bank needs $500 million for 30 days to fund its dollar loan book. Three funding paths are available:

• Unsecured Eurodollar deposit. Borrow from a Singapore money-market fund at SOFR plus 15 bps. Total cost at 5 percent SOFR: about $2.15 million for 30 days.
• FX swap. Deliver Korean won spot, receive dollars, reverse in 30 days. If the KRW/USD basis is -20 bps, the all-in cost is SOFR plus 20 bps, or $2.18 million.
• Repo against Treasuries. Post US Treasuries as collateral at SOFR plus 5 bps. Cheapest at $2.08 million, but requires eligible collateral on the balance sheet.

If the bank cannot find enough unsecured funding and its Treasury inventory is limited, it defaults to the FX swap. Aggregate demand for that path is exactly what drives the cross-currency basis wider during stress.

Common Mistakes

1. Thinking the market only involves European banks. The name is a historical artifact. Tokyo, Hong Kong, Singapore, and Cayman Islands account for a large share of offshore dollar booking. Any dollar deposit held outside US borders counts.

2. Confusing Eurodollars with the euro currency. Eurodollars are US dollars. Euro-euros (dollar deposits in Europe denominated in euros) are euros. The "Euro" prefix predates the 1999 launch of the euro currency by decades and describes location, not denomination.

3. Underestimating the systemic size. Offshore dollar claims on non-banks are estimated at roughly $10 trillion. When that market seizes, as in September 2008 and March 2020, the Fed must lend through swap lines to foreign central banks to prevent a global dollar shortage.

4. Assuming SOFR replaced the entire Eurodollar complex. SOFR replaced USD LIBOR as the reference rate. The underlying offshore deposit market still exists and continues to grow. What changed is the benchmark, not the plumbing.

5. Ignoring the regulatory arbitrage angle. Offshore booking can reduce capital requirements, reserve requirements, and certain reporting obligations. Post-2008 rules (Basel III, leverage ratios, G-SIB surcharges) closed many gaps, but subsidiaries in low-regulation jurisdictions still exist for legitimate and cost reasons.

Frequently Asked Questions

Q: What is the Eurodollar market in simple terms? It is the global pool of US dollars held in bank accounts outside the United States. Non-US banks need dollars to finance trade, lend to multinationals, and settle derivative contracts, but they cannot borrow from the Federal Reserve directly. The Eurodollar market is the private network that supplies those dollars.

Q: How does the Eurodollar market affect investment decisions? It is the plumbing of global dollar liquidity. When the market functions, non-US banks fund international operations cheaply. When it seizes, dollar shortages spread across asset classes simultaneously. Monitoring Eurodollar funding costs, Eurodollar deposit rates, FX swap implied yields, cross-currency basis, gives early warning of global funding stress.

Q: What is a real-world example of Eurodollar market stress? In March 2020, global demand for dollars to cover margin calls and repay obligations overwhelmed offshore funding markets. The Federal Reserve extended over $500 billion in swap lines to foreign central banks within days, allowing them to redistribute dollars to their domestic banking systems and preventing a global dollar shortage from freezing international credit.

Q: How can investors use knowledge of the Eurodollar market? Watch cross-currency basis swaps and FX swap implied yields as early stress indicators. When offshore dollar demand surges ahead of a Fed reaction, the basis widens fast and non-US asset prices follow. The Eurodollar market gives the first signal of global dollar stress, often days before equity volatility spikes.

Q: How is the Eurodollar market different from the US domestic money market? Domestic US money markets are regulated by the Federal Reserve, backed by the discount window, and covered by deposit insurance. The Eurodollar market sits outside Fed direct oversight, has no discount window access, and is funded by wholesale interbank and money-market fund flows. That is why Fed swap lines are needed in crises, Eurodollar banks cannot go to the Fed directly.

Sources

1. Bank for International Settlements. "The global US dollar funding system." BIS Quarterly Review. https://www.bis.org/publ/qtrpdf/r_qt2012.htm
2. Federal Reserve Board. "International Banking and Dollar Funding." FEDS Working Paper. https://www.federalreserve.gov/econres/feds/files/2020027pap.pdf
3. International Monetary Fund. "The Global Dollar Cycle." IMF Working Paper. https://www.imf.org/en/Publications/WP/Issues/2022/10/14/The-Global-Dollar-Cycle-524561
4. Securities Industry and Financial Markets Association. "US Fixed Income Markets Overview." https://www.sifma.org/resources/research/us-fixed-income-securities-statistics/

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.