The Hidden History of Eurodollars, Part 1: Cold War Origins

but particularly Soviet and Chinese history. And one thing I've learned, and this did actually come up on an old episode, there's some interesting financial linkages in the past that people might not have expected at all, and I feel like more people should be talking about this.

financial system. Just a lot of fascinating history to satisfy your new middle aged man fans.

especially when Marshal Tita takes over in Yugoslavia. So in nineteen forty five and November there's a communist revolution and the US is miffed in a bunch of ways, but one of them is that the old government owes them money, and so the question is how are they going to get it? And a few months later, Tito asked for his gold back because the Yugoslav government had seventy million dollars worth of gold in New York, and the Secretary of State, George Marshall, of the Marshall Plan, he realizes

he's got a bargaining ship, which is the gold. It's in New York, and they don't get it back until they settle their claims. Now, even people within the State Department were kind of skeptical of this. The Yugoslavian government is obviously furious, and so the Russians, who at this point, you know, Tito and Stallin have a falling out eventually a few years later, but at this point they're quite closely aligned, and so the Russians are furious. The Yugoslavian

government is furious. The State Department internally has some turmoil over this, and they take it to the UN, which has just been constituted, and the UN says pass they won't consider the claim, and so the Russians get the sense that the US is willing to use gold as a bargaining ship. They'd previously actually been building up dollar balances in New York. This is kind of a misnomer

about the post war period. There's this sense that the Russians are extracting all their resources from but they're actually building up reserves of dollars because the thought is, we're probably going to need to trade with these people. We have a trading company based in the US, and they need resources, and so they're building up foreign currency deposits and gold. But in nineteen forty seven they realize it's not going to go well potentially, and they.

gold is the basis for the monetary system. And so the question is where can they put gold and dollars in a safe place that's still on the right side of what was then already known as the Iron Curtain. And so it turns out Paris is the ticket. They've actually been secretly stockpiloting cash and gold in Paris. They put it in briefcases. They would fly people to Paris and put it in the consulate offices. They would just

build up piles of cash and gold. And in particular there's a bank b SENT that I won't try to do it in French and BCN is owned by or run by a notorious communist synthesizer who has a very

good relationship with the Palaparo. And so there's a friendly bank and so they take on deposit the Soviet money and Bsen's moniker and the telex system that they used to communicate was Eurobank, and so euro dollars were initially in the late forties just deposits issued by Eurobank BCN generally for the Soviet, so they're also for the Chinese.

And slowly this starts to percolate. There's another communist O one bank in London, there's one in Brussels which DCIA just describes as run by someone with few scruples, I think was the way they put it. And so there's some friendlies across Europe are willing to take their money, and the euro dollar market begins this way, which is preempt to sanctions evasion, basically that we might be sanctioned.

It happened to Tito, it might happen to us, and so we need a safe place to go, and the European regulations allowed for this, and they need dollars again because they trade with the West, and so the first severe dollars is for that, and also to replace the salaries of striking French coal miners. See an Their potential place to do this is the record's not super clear.

a bank headquartered in New York. And I think it's helpful to think about why we even hold the dollar liabilities of a bank headquartered in New York, Like even today, when you log onto your bank account and you see a balance five thousand dollars, ten thousand dollars, the bank doesn't hold US government dollars to back that, and yet we are very comfortable treating those as equivalent. We aren't concerned that those those dollars are not the same thing.

And why is that? There's a number of factors that go into it. Of course, since nineteen thirties, we've had deposit insurance up to a two hundred and fifty thousand dollars balance. Of course, businesses routinely hold larger balances and they are comfortable treating them as equivalent. Well, there's the implicit backing of the United States that comes from the fact that your bank was actually chartered by the US government, it's supervised by the US government. There's a sense that

it's backed by the US government. And then there's the actual institutional apparatus of the Federal Reserve, which has a facility the discount window. And if you do go to your bank and say I actually want to turn this balance into government cash, the bank can go to the Federal Reserve and get that cash. The FED can print it for the bank and hand it over. And so there's this whole apparatus that facilitates you treating your balance

at a US bank as equivalent to government cash. Those are trading at par This bank over in France that's now issuing these dollar liabilities that the Soviets are holding.

Why should we think that that should maintain par equivalents to US government dollars, that bank's not FDIC insured, that bank's not chartered by the US government, that bank's not supervised by the US government, and that bank can't call up the FED when the Soviets are drawing down their balance, and the FED won't print money and hand it over.

And so this move by the Soviets, they're taking on a lot of risk to get out of the US, and they're doing it because they're worried about the risk on the other side, the Yugoslavia risk, the risk that the US will actually freeze their balances, and so they have much higher risk tolerance, and they are willing to go out and try something different, which is whole dollar balances offshore.

and then it lost that status in the thirties. But at that time dollar acceptances, which is a form of trade finance, were larger than ones drawn on London, and the dollar was the currents eve international trade and in particular the reserve currency of the world. It was the largest, was much bigger than Stirling, at least for a few years. And as a consequence of that, some of the Austrian

banks in particularly started issuing dollar deposits. There's one in particular in Austria that did a pretty brisk business in this, and they were doing inter bank deposits. They were doing private deposits like non bank deposits. It looked a lot like the euro dollar market. The difference is they were basically holding it in cash on the other side, so it was more of a correspondent custody type arrangement. And so the question for a bank taking deposits is not

are you comfortable issuing deposits? Of course they're comfortable issuing deposits. What are you going to do with the money? And so what can a communist own bank in Paris in nineteen forty eight do with the money? And at the time there was still some trade between the East and

the West cross Iron Curtain. Now the Soviets don't like this in general because they have this policy of self reliance for obviously, since they don't want to rely in the West for anything, and we actually don't know how much of their trade this was because you'd be sent to the goolog for talking about economic data, So no talking about payrolls Joe in Soviet Russia in the forties, at least starting in the forties. But the key was there was enough to make a business out of it,

and it was in dollars. So using these dollar deposits to finance East West cross Iron Curtain trade was profitable in two respects. One is you just making more money on loans and you make on cash. The others you don't have to hedge it because you have a dollar asset a dollar loan to facilitate trade, and a dollar liability a dollar deposit, so you're not taking foreign exchange risk. And so that turns out to be an okay business. Like there's not enough of that to make for a

large market, but it grows. You know, it's two hundred million dollars in the early fifties and so like this is the seed that's planted, and it basically sets a precedent, which is banks are willing to do this. But the question is how do you make this a bigger business? What are the business opportunities to do it, and that's where the early fifties are a critical period because after the war, most foreign exchange markets are you're straight up closed.

The British in particular are like heavily controlling their currency. London's the obvious place to do this kind of business.

you care mostly about Stirling. Then in nineteen fifty two, as things are starting to improve, the Marshall Plan is mostly done, the dollar gap has been mostly filled. We'll talk about that a little little bit, and things are normalizing, so the British feel comfortable partially liberalizing their foreign exchange markets now, not all at once. The spot meaning today you want to exchange sterling for dollars, the rate at which you can do. That is still heavily controlled by

the Bank of England. It's in a range that's widened, but it's still pretty narrow. But in particular they've liberalized the foreign exchange futures market or forward market. So what is a foreign exchange forward. A foreign exchange forward is I'm going to give you dollars for sterling, not today, maybe tomorrow, maybe in a month, maybe in a year. This is a very very large market today. It's a critical piece of hedging equipment for a bank because you

can use those forwards. If you've borrowed dollars and lent them out for say a year, you don't want to hedge your dollar risk today. You want to hedge it for the return of those dollars in a year. You want a coverage for the full term of the loan. So the forwards market is critical to this, and so the Bank of England says, now you can trade forwards on dollar, sterling and other major currencies, but in particular dollars sterling, and we won't control that rate. So now

there's a hedging instrument. And now banks in London can look around and say what can I do with this? Because there's clearly interest as a precedent for dollar deposits, and then the question is what can I do with it?

just cross border interest rate arbitrage. Today we'd call it a cross currency basis, but it is not perfectly efficient, meaning if there's more demand for dollars or more demand for sterling, the pricing can get out of whack relative to the relative.

And that sounds really technical, but what it's really doing is using foreign exchange markets and derivative markets to source dollars that the UK particular needs in this post war environment. So imagine a euro dollar bank. A eurobank takes in a euro a dollar deposit, which means it gets a dollar in cash. Let's think of a physical bill. That's an asset. It issues a euro dollar liability, and then what is it going to do next, because it needs

to do some sort of investing. And what it does is it exchanges that dollar asset for a sterling cache and it invests that sterling cash in some short term sterling investment that's short bills or something like that. And after it does that, it says, I want to hedge my foreign exchange risk because now I have a dollar liability and a sterling asset, So I'm going to use the foreign exchange forward market to agree to sell that sterling back for dollars at some point in the future

at a fixed price that we agree on today. So that's the bank's position. Who's on the other side of that trade. Let's say a corporation, a manufacturing entity. They

make radios, and that radio production process requires inputs. Those inputs are imported, and so that radio production company needs dollars with which to buy the raw materials that it uses to make the radio that it then sells four dollars in foreign markets, and so they get those dollars from the Eurobank in exchange with the sterling they have

on hand. They go buy all the parts, but they want to make sure that they know how much they're going to receive in local currency at the end of the production process when they sell that radio broad They don't want the value of the dollar to go down, so they sell those dollars forward in exchange for sterling, and so they ventured into a derivative agreement, which is the opposite of the one that the Eurobank has or

the eurobanking system. And so then they put together the radio, they sell it abroad, they receive dollar proceeds, turn those into sterling, which is what they pay their employees in that's what they pay for their land and equipment in and that exchange rate was the one they agreed upon

in advance through the foreign Exchange forward contract. And so basically what's happening is the eurobanks are pulling in dollars from abroad, distributing them through the foreign exchange market that's trading on shore to those that need dollars today, and then providing hedges to those that will receive dollars in the future, and in the case of the Eurobank, the dollars they'll owe in the future potentially to the euro dollar deposit holder.

now and not on starling. And so the euro dollars are sort of worth the risk to the City of London and to some extent to UK financial regulators like the Bank of England, because they need to fix their business model for a dollar world, and they want to get in on the dollar world. Dealing in dollars is going to be a necessary part of that, and so the UK is adapting here by turning to dollars and embracing dollar liabilities for its own institutions.

call now like a use case. Right, there's like a real underlying use case that doesn't involve the Soviet Union for dollar deposits issued by non US banks, which you can't emphasize enough how fundamentally strange that is, because if I tried to make dollars by writing another piece of paper, I don't think I'd get very far. But at the time that's essentially what these banks are doing, and in particular London is a more let's say, reputable locale, particularly

banks that are not known to be Communist sympathizers. There's a little bit of a funny thing about being a communist bank, but we won't get into that specifically, but these are blea chip banks in London issue even dollar deposits and that means you can use them for things and you can feel more comfortable. Along the lines of what Love was talking about, you can feel much more comfortable with Midland Bank, which was among the largest in the city, than BSEN, which is a tiny little place

on the continent. And so the market starts growing. It has a bunch of things going for it, and the most important, arguably is that they can pay higher interest rates than banks in the US in general. I think you've done podcasts before about the impact of regulation Q at different times. Regulation Q is a ceiling interest rates

that banks can pay. It's a depression your regulation designed to mitigate races to the bottom and bad decision making among commercial banks, and so they are limited in what they can pay. Now, we don't have to talk about whether or not that should or should not have been done. It was definitely in place in the fifties and sixties, and so if you go to London there is no regulation queue, so you can offer dollar deposits and pay

a higher rate of return. So that's more money, right, So that's appealing as long as you can get your head around the counterparty risk meeting. This is not a New York Bank they don't have.

dollars are issued by non communist banks. And even then there were thirty six circuits, which means if you want to call New York from London, you have to wait online for one of thirty six open lines at some point during the day, which could take a long time. Was very expensive and perhaps more problematically, these cables would get cut with some frequency, and so you've got one transatlantic cable that can get cut for any number of reasons,

with indeterminate resolution times, and so it's just hard. There was a telegraph cable, but like that wasn't great, and so basically it's just like annoying to deal with an overseas bank, especially if you need money soon. So New York banks would generally not offer same day liquidity.

It's still inhibited on the continent because you haven't restored full convertibility until nineteen fifty eight, but at that point you do, and you have this dramatic expansion, and you're at all deposits, in particular their use for the thing for which they will become famous, which is trade so now most cross border trade or intra European and global trade is done in dollars. That's a breton Woods thing. We'll talk about breton Woods later, but you essentially have

to use dollars to do international trade. You often need to borrow money to facilitate trade. Trade is very heavily dependent on credit. So now you have the beginnings of a real like I said, was a real business when you're doing a cross border arbitrage, but that goes away if enough people do it. Trade is expanding dramatically. The world in the late fifties is growing enormously quickly, and

a lot of that is driven by international trade. So the demand for credit to facilitate that trade is growing just as fast as the trade itself, and a lot of other banks start to get in on the action. So what was a London city bank dominated market city of London banks becomes really international market based in London. So by the early sixties there are a bunch of US banks who have opened branches in London to facilitate

your dollars. They find this to be a good way to get around regulation que because I want to pay up for deposits, I can't do that in New York, I might as well just do it in London. It's all dollars at the end of the day. So they having branches in London. They're Japanese banks in London. There are Continental banks in London. There's euro dollars in Paris and Milan. So it's turning into a real global business, all in dollars, and so that obviously gets everyone's attention

and it starts to raise a few eyebrows. And this is where people start to notice who are not directly involved in the market. It was previously kind of a practitioner's market. If you were involved in international trade, fans you would know about your dollars, but I wouldn't say anyone on the street would know about your dollars now. But if you were involved in finance, now you've heard

of them. That becomes to be more the case, and by the late fifties they attract the attention of the Federal Reserve, who actually gets an inquiry from a third party saying these are interesting, why don't you look into it? And so they dispatch a couple of senior officers, Allen Holmes and Fred Klopstock. Allen Holmes becomes a sower manager eventually, and Fred Klopstock is kind of like this giant of international finance, so though he's at the beginnings of his career.

But senior officers, you know, they run departments and they're sent to Europe on.

don't know, by the way, how big it is. They just know it's big. So they know it's at least a billion dollars, which back in the day was a lot of money.

this market subsequent to nineteen sixty. It's still pretty nascent in nineteen sixty. It's where some action is in London. The policymakers here, they're already on top of this at half the size of a tether, and they're off trying to get to the bottom of what's going on.

what does useful mean? And useful in this context means you're earning enough interest on this dollar that you're willing to hold it as a dollar deposit and on the other hand, like you're willing to hold dollars in balances instead of spending them immediately, and so like this is a short term liquid investment in dollars that is appealing, especially to the central banks, which are rapidly accumulating dollars through the growth of international trades, so they need somewhere

to put it. You know, if I'm at central bank, I taken a dollar, I can go turn it in for gold. If I want gold, I can hold it as a dollar, maybe buy treasury security, or I can put it in a year dollar bank, and something like one out of five of the early year dollars maybe more.

too many claims on its gold. They'd issued a lot of dollars. Those dollars were exchangeable for gold, and now there were way more dollar claims on their pile of monetary gold than there was gold, and increasingly people were turning their dollars in.

the useful form of money. But when you're talking about international trade and finance, currencies are in legitimate competition with each other for uses, and so you know, put your core or treasurer hat on of a nineteen fifty's UK business engaged in import or export. Part of what Josh is illustrating is suddenly the dollar is a more attractive currency to use in various ways because you can maintain dollar balances at a nearby bank that you've banked with,

you have a strong relationship with. You don't need to have some transatlantic relationship with the New York banks. So suddenly there's more transactions that you will do, trade financing and actual trade invoiced and denominated in dollars because suddenly the dollar is a more appealing currency for you. So

the dollar's usefulness has grown. And to the New York Fed team that is looking into this, they are pleased with this development to see that the euro dollar market, this nascent development of European sovereigns essentially is actually going to be a good thing for the currency that we in the United States are creating in terms of its competitiveness with other currencies in the global marketplace.

There's massive trouble brewing and the whole global edifice of the dollar system is starting to crack, and the question is, you know, how are we going to save it?

thanks to our sound engineer Blake Maples. From our odd loads content, go to Bloomberg dot com slash odd Lots, where we have transcripts, a blog, and a daily newsletter and you can chat about all of these topics twenty four to seven in our discord discord dot gg slash odd lots.